Multi-layer model of correlated energy prices (Q847241)

The authors develop an extension of the affine jump-diffusion modeling framework and use it to build an intuitive, elegant and tractable model for an energy price complex. The multilayer model incorporates realistic inter-commodity dependence while it also reproduces the unique characteristics of electricity spot prices and allows fitting any initial forward term structure. Because of these properties the model is particularly well-suited for valuing a range of typical derivatives traded in the electricity markets such as: cross-commodity spread options, cross-location spread options, fuel-switching power plants, etc. An approximate pricing method for these derivatives is provided together with precise error bound estimates. The authors suggest that the error bound from the empirical example could be improved by a better choice of the Taylor expansion point of origin and leave for future work the selection of option strike-dependent approximation of points of origin.