Hedging Strategy and Electricity Contract Engineering - IFOR
Hedging Strategy and Electricity Contract Engineering - IFOR
Hedging Strategy and Electricity Contract Engineering - IFOR
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36 The electricity market<br />
6<br />
5<br />
4<br />
Annualized volatility<br />
3<br />
2<br />
1<br />
0<br />
1998−01 1999−01 2000−01<br />
Fig. 2.13: Rolling volatility calculated from a monthly window of the daily<br />
spot price at Nord Pool from 1997-12-30 to 2000-05-06.<br />
The spot increments dS t in (2.2) has a deterministic part, given by aS t dt,<br />
where a is the drift in the spot price. It also has a stochastic component, given<br />
F by SdW t , where the F constant denotes volatility. Figure 2.13 shows that the<br />
volatility of electricity prices is not constant, why a time dependent volatility<br />
t may be preferred when modeling electricity prices.<br />
F<br />
<strong>Electricity</strong> prices are however fundamentally different from stock prices why<br />
the simple geometric Brownian motion is not sufficient to model electricity<br />
prices.<br />
2.9.1. Mean reversion<br />
Energy spot prices in general are mean reverting [GS90] <strong>and</strong> electricity prices<br />
in particular seem to move around some sort of equilibrium level, a so-called<br />
mean level. <strong>Electricity</strong> prices are hence regarded to be mean reverting. This<br />
feature is normally modeled by having a drift term that is negative if the spot<br />
price is higher than the mean reversion Q level <strong>and</strong> positive if the spot price is<br />
lower than the mean reversion level <strong>and</strong> the simple geometric Brownian motion
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