Pricing electricity derivatives within a Markov regime-switching model: a risk premium approach (Q2441572)

To price electricity derivatives, the author uses a Markov regime switching process \(X_t\) with three states: a base regime, corresponding to ``normal'' prices; a spike regime, corresponding to sudden upward price jumps; a drop regime, corresponding to sudden price drops. The process \(X_t\) can jump to a different regime only at discrete time points. The state of the market is described by a discrete-time Markov chain \(R_k\) defined by a time-varying (periodic) transition matrix \(P(k)\). The base regime dynamics is given by the Vasicek model. The spike regime values are independent and identically distributed (i.i.d.) random variables with shifted log-normal distribution. The drop regime values form an i.i.d. sample from an inverted shifted log-normal distribution. Then the electricity spot price is given by \(P_t=g_t+X_t\), where \(g_t\) is a deterministic seasonal component. By using the concept of the risk premium (reward for investing into a risky asset instead of a risk free one), the author obtains analytic formulas for electricity derivatives. The obtained theoretical results are tested against European Energy Exchange data.