Modelling electricity prices and implications for option pricing

Abstract

The pricing of options is generally dominated by the Black-Scholes approach. The characteristics of electricity prices, however, appear incompatible with the assumed process underlying the Black-Scholes model (ie. Geometric Brownian Motion). This thesis examines the potential for option pricing biases when applying the Geometric Brownian Motion (GBM) model in the context of the New Zealand electricity market. Two alternative models, Geometric Mean Reversion (GMR) and Geometric Mean Reversion with Jumps (GMRJ), are tested against the GBM.

Beginning with an examination of the NZ electricity market and price process, this study identities and explains some of the characteristics of electricity prices. Then it identities and fits the appropriate price process models to the spot price data. The results indicate that the GMR model is the best representation of the electricity price process in the New Zealand context, while the GBM model is the least accurate. Moreover, simulating option prices for these models under different scenarios reveals that the GBM model significantly overprices electricity options in most cases. Option prices generated by the GMRJ model are generally not largely different from those of the GMR model.