Derivative pricing and trading strategies

Elliot Tonkes (Presented at AMSI Conference on the Mathematics of Electricity Supply and Pricing, April 2007)

Objective: The objective of the workshop is:

  • to provide electricity market representatives with an overview of certain mathematical techniques which are applicable to solve several real-world industry problems
  • to provide mathematicians without significant industry knowledge with an overview of the energy markets, exposure to some relevant problems and to demonstrate mathematics to solve those problems.

The main objective of this workshop is to cover the derivative markets. The talk will demonstrate several pricing techniques, concentrating on pragmatic approaches. Time will be spent illustrating the main classes of derivatives that are traded in the markets, and the commercial drivers behind the contracts.

As the main volume of derivatives are held for risk management purposes, the workshop covers the construction of a portfolio of derivatives and trading strategies to manage the derivatives and to achieve certain portfolio risk-return objectives.

As the derivatives are written on a complex underlying physical model, a substantial introduction to the Australian physical National Electricity Market is included.

Part 1. The physical Markets

  • How the NEM works
  • Models of price and demand dynamics:
    1. stochastic differential equation models
    2. dispatch models
    3. randomized models based on historical sampling
    4. Principal Components Analysis
  • Drivers of price outcomes and volatility
    1. Demand
    2. Transmission
    3. Outages
    4. Bidding behaviour
    5. Regulatory environment
  • Mathematical techniques to estimate revenues or volume weighted average prices (inner products of volume and price stochastic processes)

Part 2. Derivatives and derivative pricing

A description and motivation of industry-standard derivatives, presentation of pricing methods and concepts of volatility:

  • Swaps
  • Options on swaps
  • Asians
  • Caps and floors
  • SRA contracts

Part 3. Exotic derivatives and trading strategies

  • Delta hedging in the real world
  • Physical plant valued as a real option
  • Contracts with nominations
  • Development of a dynamic programming method to price and manage a curtailment contract

Contact the author for further details.