Practical Valuation of Power Derivatives

In this paper 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, we just have to mention the Black-Scholes-Merton model to remind us of that. This also brings to mind some big swinging traders who have told me that they don’t care about the theory, and the very next second were looking at the Black-Scholes-Merton delta on their Bloomberg screen to hedge some options. 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. The Black-Scholes-Merton model or its binomial equivalent is a great example of making things simple enough, but not simpler than that, at least when it comes to equity, futures or currency options. Still, as we will see the Black-Scholes-Merton model, or rather the formula will not necessarily do without some modifications when applied to the electricity market. This article was written during a research sabbatical from trading, to be honest most of this article was written from a bar in the town of Trondheim, one of the greatest university towns on this planet. To write or read about formulas and abstract mathematics is in my experience best done in a relaxing atmosphere. A frozen margarita could certainly help you absorb this article once you have finished reading it, or better still before.

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