On the control of the difference between two Brownian motions: an application to energy markets modeling

TL;DR

This paper introduces a dependence model for two Brownian motions that captures dynamic correlation states, enabling better risk management and option pricing in energy markets by reflecting asymmetries in price differences.

Contribution

It proposes a novel dependence structure based on reflection and barrier concepts, allowing for state-dependent correlation between Brownian motions, unlike traditional constant correlation models.

Findings

Model captures higher probability of small differences than constant correlation models.

Enables modeling of asymmetry in electricity and combustible price differences.

Applicable to risk management and option pricing in energy markets.

Abstract

We derive a model based on the structure of dependence between a Brownian motion and its reflection according to a barrier. The structure of dependence presents two states of correlation: one of comonotonicity with a positive correlation and one of countermonotonicity with a negative correlation. This model of dependence between two Brownian motions $B^1$ and $B^2$ allows for the value of $\mathbb{P}\left(B^1_t - B^2_t \geq x\right)$ to be higher than $\frac{1}{2}$ when $x$ is close to 0, which is not the case when the dependence is modeled by a constant correlation. It can be used for risk management and option pricing in commodity energy markets. In particular, it allows to capture the asymmetry in the distribution of the difference between electricity prices and its combustible prices.