Electricity contracts differ substantially from financial contracts
making traditional derivatives inapplicable. The main difference
lies in the inability to store electricity causing the production to
cover demand instantaneously. Therefore, electricity prices often
jump to a multiple of their current value only to come back to
normal level within a few hours. Spot price volatility is driven by
demand whereas prices in the long run are rather affected by the
physical ability of technology and generation capacity. A one factor
price model like the geometric Brownian motion is insufficient to
capture the mean-reverting behaviour of the electricity prices. The
model needs to be extended by an additional stochastic factor to
reflect electricity price movements realistically.
The evolution of sophisticated models and numerical techniques had a lasting effect on the risk perception of companies active in these markets. Facing the problem of managing their risk exposure, market participants seek to offset their risk by hedging and rebalancing their positions. The approach is referred to as the ‘Greeks’ or sensitivity analysis whereby each risk factor is assigned to a 'Greek Letter'. An alternative risk management technique which summarizes the total risk in a single number is known as VaR. Despite its popularity, the VaR concept should be handled with caution when it is applied to electricity markets.
This work aims at providing further insights into risk management in electricity markets in general and into sensitivity analysis in particular. The goal of this paper is a systematic analysis and comparison of the ‘Greeks’ under the assumption of different price dynamics. Moreover, it tries to demonstrate the limits of traditional risk management methods such as VaR and their modification. In the last part, model test are carried out in order prove the accuracy of the used software tool for option valuation.
|type||working paper (English)|
electricity derivatives, sensitivity analysis, value at risk, greeks, 2 factor model
|date of appearance||2007|
|issuer institution||ior/cf-HSG, University of St. Gallen|
|citation||Frauendorfer, K., & Vinarsky, A., ior/cf-HSG, University of St. Gallen (Eds.), (2007). Risk Measurement in Electricity Markets.|