Energy Power Risk Management: Option pricing for power prices with spikes

Cyriel de Jong and Ronald Huisman have written the following article about the topic of Option Pricing. It appeared first in 2003 in the Journal of Energy Power Risk Management. The authors examine the impact of spikes on option prices. They compare prices from a standard mean-reverting model to a regime model that disentangles the spike process from the mean-reverting dynamics.

Summary article: Option pricing for power prices with spikes

European power prices are very volatile and subject to spikes, particularly in German and Dutch markets. The authors present a model for valuing options on electricity spot
prices. First of all, the model takes into account the two main features of electricity prices: strong mean reversion and occasional spikes. “We obtained pricing results by disentangling the mean-reverting spot prices from the spikes, so that option values could be broken down into two components. We then showed that it is crucial to include spikes in any option price formula, as they represent substantial value, especially for deep out-of-the-money options.”

The result of this approach has important implications for capped electricity contracts. The mean-reverting model would severely underestimate the costs of a maximum price (or cap). Therefore it is important to be able to include spikes when pricing options – otherwise you leave money on the table.

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