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Finance, Economics, and Mathematics by Robert C. Merton, Oldrich A. Vasicek

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Chapter 29Plugging into Electricity

By Hélyette Geman and Oldrich Vasicek

Risk 14(8) (2001), 93–97; reprinted in A. Lipton (ed.), Exotic Options: The Cutting Edge Collection (London: Risk Books, 2003).

Forward and Futures Contracts on Nonstorable Commodities: The Case of Electricity

Most of the literature about modeling commodity spot and futures prices has dealt with storable commodities, such as wheat, gold, and oil. However, the deregulation of energy markets worldwide over the past few years has paved the way to free electricity markets, both for spot and derivatives trading, and made it necessary to focus on electricity's unique features as a commodity.

The most important feature is the nonstorability of power (except for hydroelectricity). It accounts for the spikes observed during periods of extreme weather conditions and/or lack of capacity: for example, in the U.S. Midwest in June 1998; on the U.S. East Coast in July 1999; and in California in much of 2000, followed by severe blackouts in early 2001.

From a financial economics standpoint, the nonstorability makes irrelevant (as argued by Eydeland & Geman, 1998) the notion of convenience yield, which represents the benefits accrued from “holding” the commodity. It also implies the collapse of the spot-forward relationship, as its proof involves cost-of-carry arguments between the current date and the maturity of the forward contract. Besides the nonstorability, electricity has unusual physical attributes that makes ...

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