Practical Valuation of Power Derivatives*

In this chapter I look at the practical valuation of power derivatives from a trader's perspective. Most people that have written about valuation of power derivatives are academics or quants working in the research departments of large organizations far away from the trading desk. Most of them have never traded a single power option. In general there is nothing wrong with that as some of the greatest practical research in quantitative finance has come out of academia and research departments. Anyway, when it comes to electricity derivatives most academics have made simple things too complex and at the same time have forgotten simple things that have great importance. Still, as we will see the Black-Scholes-Merton model, or rather the formula will not necessarily suffice without some modifications when applied to the electricity market. This chapter was written during a research sabbatical from trading, to be honest most of this chapter was written in a bar in the town of Trondheim, one of the greatest university towns on this planet. To write or read about formulae and abstract mathematics is in my experience best done in a relaxing atmosphere. A frozen margarita can certainly help you absorb this chapter once you have finished reading it, or better still before.

1 Introduction

The Nordic electricity market with its exchange Nord Pool is today one of the most active exchanges in the word for physical electricity and electricity derivatives. ...

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