Energy Trading and Risk Management: A Practical Approach to Hedging, Trading and Portfolio Diversification

CHAPTER 2 Quant Models in the Energy Markets Role and Limitations

In this chapter we will examine fundamental concepts of electricity price models. There are two common approaches to modeling electricity price dynamics:

1. Movements of the forward curve and behavior of forward prices
2. Spot price dynamics and derivation of forward prices from the model

Either approach may be employed. Properly calibrated, one can transform one method into the other (Riedhauser 2003).

It is important to have an understanding of the dynamics of electricity prices in order to develop effective trading and risk management strategies.

It is important to have an understanding of the dynamics of electricity prices in order to develop effective trading and risk management strategies. Electricity—a secondary energy source—is generated from the conversion of other energy sources such as oil, natural gas, nuclear power, wind power, hydroelectric power, and so forth. Hence the price of electricity is affected by the prices of these primary energy sources.

There is no global electricity market. Hence, electricity products may vary from one regional electricity market to another. Since the 1970s some regional markets have undergone significant restructuring, in part, due to market deregulation. Worldwide deregulation of electricity markets led to the restructuring of the generation, transmission, distribution, ...