Valuing virtual production capacities on flow commodities

As a result of storability restrictions, the price risk management of flow commodities (such as natural gas, oil, and electrical power) is by no means a trivial matter.To protect price spikes, consumers purchase diverse swing-type contracts, whereas contract writers try to hedge themselves by appropriate physical assets, for instance, using storage utilities, through transmission and/or production capacities. However, the correct valuation of such contacts and their physical counterparts is still under lively debate. In this approach, an axiomatic setting to discuss price dynamics for flow commodity contracts is suggested. By means of a minimal set of reasonable assumptions we suggest a framework where the standard change-of-numeraire transformation converts a flow commodity market into a market consisting of zero bonds and some additional risky asset. Utilizing this structure, we apply the toolkit of interest rate theory to price the availability of production capacity on a flow commodity.

[1]  Xiongzhi Chen.  Brownian Motion and Stochastic Calculus , 2008 .

[2]  Steen Koekebakker,et al.  Forward curve dynamics in the Nordic electricity market , 2005 .

[3]  Hélyette Geman,et al.  Fundamentals of Electricity Derivatives , 1999 .

[4]  M. Barlow.  A DIFFUSION MODEL FOR ELECTRICITY PRICES , 2002 .

[5]  D. Pilipović,et al.  Energy Risk: Valuing and Managing Energy Derivatives , 1997 .

[6]  Eduardo S. Schwartz,et al.  Electricity Prices and Power Derivatives: Evidence from the Nordic Power Exchange , 2000 .

[7]  A. Müller,et al.  A spot market model for pricing derivatives in electricity markets , 2004 .

[8]  Eduardo S. Schwartz,et al.  Stochastic Convenience Yield and the Pricing of Oil Contingent Claims , 1990 .

[9]  N. H. Bingham,et al.  Interest Rate Theory , 2004 .

[10]  Juri Hinz.  Modelling day‐ahead electricity prices , 2003 .

[11]  Eduardo S. Schwartz,et al.  Pricing of Options on Commodity Futures with Stochastic Term Structures of Convenience Yields and Interest Rates , 1998, Journal of Financial and Quantitative Analysis.

[12]  Eduardo S. Schwartz.  The stochastic behavior of commodity prices: Implications for valuation and hedging , 1997 .

[13]  René Carmona,et al.  Pricing and Hedging Spread Options , 2003, SIAM Rev..

[14]  M. Musiela,et al.  Martingale Methods in Financial Modelling , 2002 .

[15]  M. Brennan.  The Supply of Storage , 1976 .

[16]  E. Fama,et al.  Commodity futures prices: some evidence on forecast power , 1987 .

[17]  L. Rogers,et al.  Diffusions, Markov processes, and martingales , 1979 .

[18]  Jean-Charles Rochet,et al.  Changes of numéraire, changes of probability measure and option pricing , 1995, Journal of Applied Probability.

[19]  Michel Verschuere,et al.  Pricing electricity risk by interest rate methods , 2005 .