Risk Management in Commodity Markets: From Shipping to Agriculturals and Energy

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Risk Premia of Electricity Futures: A Dynamic Equilibrium Model

Wolfgang Bühler and Jens Müller-Merbach

5.1 INTRODUCTION

Electricity futures prices generally contain risk premia or discounts on the expected spot price. As electricity is not storable, those premia do not indicate market inefficiencies due to lacking arbitrage activity, but rather reflect rational behavior of risk averse investors.

Accordingly, the explanation of electricity futures prices can be split into two problems. The first one is to determine the expected spot price for the delivery period of an electricity forward. This problem is mainly an econometric challenge. The second is to model the term structure of the risk premium which is more interesting from an economic point of view for three reasons.

First, electricity is a homogenous, exchange-traded commodity that is virtually not substitutable at short notice. Premia in futures prices are therefore not diluted by market frictions or interdependencies to related markets, but primarily reflect the market members' taste for risk. Second, knowledge of the term structure of risk premia helps an individual firm to find the optimal timing of hedging. Third, exploiting the term structure of risk premia is an interesting area for speculative traders as specialized hedge funds, which are increasingly active in electricity and other energy markets.

The literature on spot and futures markets for electricity can be classified into three groups, econometric models, ...