Modeling Term Structure Dynamics in the Nordic Electricity Swap Market

Frestad, Dennis; Benth, Fred Espen; Koekebakker, Steen
April 2010
Energy Journal;2010, Vol. 31 Issue 2, p53
Academic Journal
We analyze the daily returns of Nordic electricity swaps and identify significant risk premia in the short end of the market. On average, long positions in this part of the swap market yield negative returns. The daily returns are distinctively non-normal in terms of tail-fatness, but we find little evidence of asymmetry. We investigate if the flexible four-parameter class of normal inverse Gaussian (NIG) distributions can capture the observed stylized facts and find that this class of distributions offers a remarkably improved fit relative to the normal distribution. We also compare the fit with that of the four-parameter class of stable distributions; the NIG law outperforms the stable law in the vast majority of cases. Thus, the NIG family of distributions, which allows for stochastic dynamics in terms of L�vy processes that are suitable for pricing derivatives and Value-at-Risk measurements, is a serious candidate for modeling term structure dynamics in the Nordic electricity market.


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