The Market Price of Jump Risk for Delivery Periods: Pricing of Electricity Swaps with Geometric Averaging

TL;DR

This paper extends the pricing framework for electricity swaps by incorporating jump risk into the market price of risk for delivery periods, using a geometric averaging approach and mean-reverting jump processes.

Contribution

It introduces a jump risk dimension into the MPDP model for electricity swaps and compares geometric and arithmetic averaging methods under a mean-reverting jump framework.

Findings

Jump risk significantly affects swap prices.

Geometric averaging provides a different risk premium than arithmetic averaging.

Decomposition of market price of risk into classical and jump components.

Abstract

In this paper, we extend the market price of risk for delivery periods (MPDP) of electricity swap contracts by introducing a dimension for jump risk. As introduced by Kemper et al. (2022), the MPDP arises through the use of geometric averaging while pricing electricity swaps in a geometric framework. We adjust the work by Kemper et al. (2022) in two directions: First, we examine a Merton type model taking jumps into account. Second, we transfer the model to the physical measure by implementing mean-reverting behavior. We compare swap prices resulting from the classical arithmetic (approximated) average to the geometric weighted average. Under the physical measure, we discover a decomposition of the swap's market price of risk into the classical one and the MPDP.