Valuation and risk management in the Norwegian electricity market

Abstract

The purpose of this paper is two-fold: Firstly, we analyze option value approximation of traded options in the presence of a volatility term structure. The options are identified as: "European" (written on the forward price of a future flow delivery); and (ii) Asian. Both types are in fact written on (arithmetic) price averages. Secondly, adopting a 3-factor model for market risk which is compatible with the valuation results, we discuss risk management in the electricity market within the Value at Risk concept. The analysis is illustrated by numerical cases from the Norwegian electricity derivatives market.