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- Herausgeber: GRIN Verlag
- Sprache: Englisch
Master's Thesis from the year 2008 in the subject Business economics - Banking, Stock Exchanges, Insurance, Accounting, grade: 6.0 , University of Lausanne, language: English, abstract: The Swiss electricity market has been facing structural changes in recent years due to market deregulation activities. This development has been accompanied by the emergence of spot markets where electricity is traded between producer and purchaser. Since the price charged to the end-customer turns out to be more exposed to market prices of electricity, the need for derivatives with a risk management purpose arises. A more recent asset class such as structured products may be used as a risk management tool. This paper focuses on the pricing of various structured products with the Swiss energy price indices as an underlying. Since electricity has particular features that result in a peculiar stochastic process, the pricing of electricity derivatives cannot rely on traditional pricing formulas that have been developed for equity or commodity underlyings. Rather, there is a need for a dynamic model that captures the unique characteristics of electricity. In this paper, a new jump diffusion process is proposed and estimated that is able to incorporate the Swiss electricity price properties. Building on this model, a Monte Carlo simulation is applied that allows one to price differing electricity derivatives that are embedded in structured products. Using the option pricing results, the feasibility and attractiveness of a defined range of structured products is investigated. In order to include the special properties of electricity, new structured products are developed that are more appropriate as risk management tools. One of the main contributions of this paper is the practical approach of how to price structured products. Keywords: Electricity, SWEP, Swissix, Structured Products, Monte Carlo, Jump Diffusion, Derivatives pricing
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Veröffentlichungsjahr: 2008
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The Swiss electricity market has been facing structural changes in recent years due to market deregulation activities. This development has been accompanied by the emergence of spot markets where electricity is traded between producer and purchaser. Since the price charged to the end-customer turns out to be more exposed to market prices of electricity, the need for derivatives with a risk management purpose arises. A more recent asset class such as structured products may be used as a risk management tool. This paper focuses on the pricing of various structured products with the Swiss energy price indices as an underlying.
Since electricity has particular features that result in a peculiar stochastic process, the pricing of electricity derivatives cannot rely on traditional pricing formulas that have been developed for equity or commodity underlyings. Rather, there is a need for a dynamic model that captures the unique characteristics of electricity. In this paper, a new jump diffusion process is proposed and estimated that is able to incorporate the Swiss electricity price properties. Building on this model, a Monte Carlo simulation is applied that allows one to price differing electricity derivatives that are embedded in structured products. Using the option pricing results, the feasibility and attractiveness of a defined range of structured products is investigated. In order to include the special properties of electricity, new structured products are developed that are more appropriate as risk management tools. One of the main contributions of this paper is the practical approach of how to price structured products.
Keywords:
JEL Classification:C15, C22, C51, G13, L94, Q40
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Le marché électrique suisse a subit des changements structurels récemment dû aux activités de dérégulation de celui-ci. Ce développement a été accompagné avec l’apparition de marchés spot où l'électricité fait l'objet d'échanges entre le producteur et l'acheteur. Étant donné que le prix facturé au client final devient plus exposé aux prix du marché de l'électricité, le besoin pour les instruments dérivés avec un gestion de risque se pose. Une classe d’actifs plus récente: les produits structurés peuvent être utilisés comme un outil de gestion du risque. Le présent document se concentre sur la fixation des prix de divers produits structurés avec les indices de prix de l’énergie suisse comme sous-jacents.
Comme l'électricité a des caractéristiques particulières qui se traduisent par un curieux processus stochastique, la tarification des dérivés de l'électricité ne peuvent pas compter sur des formules de prix traditionnelles qui ont été développés pour l'équité ou des produits de base. Au contraire, il est nécessaire de disposer d'un modèle réaliste qui rend compte des caractéristiques uniques de l'électricité. Ce document propose et estime un nouveau processus de saut de diffusion qui est capable d'intégrer les propriétés du prix de l'électricité suisse. S'appuyant sur ce modèle, une simulation de Monte Carlo est appliquée qui permet à des prix différents électricité dérivés qui sont incorporés dans des produits structurés. En utilisant l'option de tarification résultats, le document examine la faisabilité et l'attractivité d’une gamme définie de produits structurés. Afin d'inclure les propriétés spécifiques de l'électricité, de nouveaux produits structurés sont développés que sont plus appropriés comme les outils de gestion des risques. L'une des principales contributions de ce document est l’approche pratique sur la façon de tarifier des produits structurés.
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This paper has turned out to be a demanding project that would not have been possible without the help and support of different people.
First of all, I am very grateful towards Clariden Leu AG for sponsoring this thesis with an internship and giving me an insight into the practice of structured products. A special thanks goes to Hans Nützi for the placement and the opportunity. Furthermore, I would like to thank the team that has been a great support in providing me with a profound insight into structured products. In particular, Yvan Meier and Urs Pfister have been a valuable source of information.
Second, I must express my thankfulness towards my family that has supported my education in every way. Also, I would like to thank my girlfriend Lorena for her continuous support.
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List of Abbreviations
a.m. Ante Meridiem (before noon) c Call Option Premium APX Amsterdam Power Exchange cp Coupon Payments ATM At The Money cpt Capital Protection Bn Billion D Dividend Payment BKW BKW FMB Energie AG F Forward Price Cert. Certificate K Strike Price
θCHF Swiss Franc(s) Mean Reversion Speed CPN Capital Protected Note N Number of Trajectories EUR Euro(s) N(x) Probability Value for Normal Distribution EEX European Energy Exchange p Put Option Premium EIA Energy Information Administration r Interest Rate EXAA Energy Exchange Austria RV Nominal Value GMM General Method of Moments σ Volatility of the Underlying Giga Watt Hour, 109W h GWh S Spot Price of the Underlying IEA International Energy Agency t, T Moment of Time, Time at Maturity ITM In The Money V0Issue Price
LEPO LLN MLE Maximum Likelihood Estimate y Number of Call Options NYMEX New York Mercantile Exchange OMEL Operadora der Mercado Espanol de Electricidad OTC Over the counter OTM Out of The Money OU Ornstein and Uhlenbeck Phelix Physical Electricity Index P/S Price to Sales Ratio SFOE Swiss Federal Office of Energy SPA Structured Products Association SVSP Swiss Structured Product Association Swissix Swiss Market Segment at EEX UK United Kingdom USD US Dollar(s) VSE Society of Swiss Electricity Companies ZC Zero Coupon Bond
Florian Giger Structured Products on Electricity
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1. Introduction
Electricity is essential for modern society, which is why a centralized regulation of the electricity supply has always been considered cogent to guarantee a secure and stable supply. Traditionally, the power industry has been characterized by vertically integrated companies. However, for the past 15 years, electricity markets in Europe have been undergoing a phase of deregulation (Weron, 2006), and have now evolved to liberalized markets where consumers can choose their electricity provider (Vattenfall, 2006). Power suppliers, networks, and endcustomers have become independent from each other. In order to facilitate the interaction between these market players and to ease the trading of electricity, different markets and exchanges have been founded across Europe.
In Switzerland, the process of deregulation has just started and is currently a hot topic of debate. In 2007, new legal standards were established that have been changing the vertically integrated industry towards a more liberalized market environment where electricity is traded between the producer and the supplier. After 2008, large end-customers will be able to choose their electricity provider. In around five years, all customers will be able to choose their power producer (VSE, 2008). This deregulation of the electricity market in Switzerland has a strong impact on the power industry. Increased competition enforces price pressure, so prices for the end-customer are expected to be closely determined in the market of electricity demand and supply. This will ultimately lead to a more volatile and stochastic electricity price development. Furthermore, the electricity prices in Switzerland have been steadily rising and are expected to further grow, despite deregulation (Gerber, 2008). As a consequence, the amount of electricity price risk borne by all market participants is increasing. Due to the new price risks, the need for risk management is growing. Different hedging tools for producers and suppliers of electricity have already been developed. Futures, forwards, plain-vanilla, and exotic options are widely used in practice (James, 2008). However, most derivatives are only traded over the counter (OTC) between the producers and the networks. Since end-consumers have only limited access to OTC markets, a product is required that offers the customers and the investors the possibility to hedge their pricing risk and to profit from increasing electricity prices in a simple way.
The purpose of this paper is to create financial products that meet these requirements. This paper will focus on the creation of structured products as they seem to be favourable investment tools for various market players. Structured products are financial products that include options and other financial products and can be tailor made to the customer’s needs.
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Creating a structured product provides the most flexibility to the customer, and may therefore be an attractive hedging tool.
This paper will focus on the Swiss electricity market, for which the structured products shall be priced. The challenging part of the valuation of the structured products is to price the embedded derivative contracts. The stochastic process of electricity shows unique characteristics so that the pricing of electricity derivatives cannot rely on traditional option pricing formulas. Rather, a method of electricity pricing has to be developed that is able to take particular characteristics into account. Since the electricity markets differ around the world in their observed price movements (Escribano, Pena & Villaplana, 2002), each market has to be examined separately. In this paper, the unique characteristics of the Swiss market are identified. The features of this market require the use of a different pricing methodology than would be applied to other markets.
This paper is structured as follows. In chapter 2, the special characteristics of the electricity market are explained. In particular, the unique nature of the Swiss electricity market is reviewed and analyzed in a way that is possible to see the implication on its price dynamic. Chapter 3 will give a thorough statistical analysis of the Swiss electricity indices, on which the structured products shall be priced. In particular, different statistical tests are applied to investigate various hypotheses of characteristics that have been observed in international electricity markets. Chapter 4 proposes a multi-factor stochastic model that is able to reproduce the Swiss electricity price dynamic. A two step procedure is applied to estimate the parameter of the model efficiently. Chapter 5 presents an overview of the structured product market and discusses new types of products that are superior in order to manage electricity price risk. Thereby, this paper introduces a new way of how to analyze the structured products. Chapter 6 performs the pricing of these derivatives on the findings of the previous chapters. A Monte Carlo simulation is used as a pricing tool since no closed-form solutions are available for the analyzed price dynamic. Furthermore, this chapter addresses the challenge of the risk neutral valuation of derivatives. At the end of the chapter, the pricing results for various structured products are presented and analyzed for their feasibility and attractiveness. Chapter 7 concludes this paper with final remarks and a presentation of issues for further research.
Florian Giger Structured Products on Electricity
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2. Electricity Market
2.1 Electricity in the Context
Commodity markets have become very popular topics of most financial and other media in recent years as there have been significant movements in many of the commodity markets (Kleinmann, 2005). Only a limited number of other asset classes have generated comparable returns in recent years (UBS, 2006).1In particular, the oil market and the agricultural market have been in the spot light due to their strong price increases that can be observed in the financial markets2. The upswings are explained by an increasing consumption and a stable or decreasing supply. The prices of commodities correlate highly with the business cycle as economic growth measures an increase in demand (CS, 2008)3. Not only the high returns but also other characteristics, such as the low correlation with other asset classes and the presumed protection against inflation, make commodities so popular among investors (Gorton & Rouwenhorst, 2004). Due to these reasons, commodities are suggested to be part of any diversified portfolio.
Electrical power must be examined against the background of the commodity markets since electricity is generated from different types of energy sources and some of them are traded on the commodity markets. Coal, gas, oil, and uranium are commodities that are often used in the production of electrical power. The prices of electricity therefore depend strongly on their market mechanics. Other energy sources, such as wind energy, solar energy, or water energy are not yet directly traded and depend therefore on other factors. In order to understand the development of the electricity prices, the behaviour of the input factors have to be understood.
2.2 The Power Markets
Electrical power is an invention that has changed human existence: it is not only essential for improving the private life but also for the economy as a whole. Due in large part to its central role in economic and social welfare, the electricity market has traditionally always been strongly regulated. Around the world, vertically integrated companies controlled primarily by
1However Gorton & Rouwenhorst (2004) claim that the performances of commodities are similar to the ones of
equity and have only outperformed in recent years.
2According to an own calculation: the Wheat price rose by 280%, the soy price by 190% and the crude oil price
by over 300% over the last 8 years.
3Compare also Gorton & Rouwenhorst (2004) for additional information. However, this has to be contemplated
for each commodity individually, as they have different drivers.
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the government have been traditionally responsible for the supply of electricity to industry and households alike. Governments have overall been cautious in leaving such an important sector to market forces. The power outage in California in 2000 and 2001 showed that defective deregulation of the power market can lead to severe consequences (Pilipovic, 2007).4Nevertheless, governments have recognized in recent years that liberalization of the power markets could introduce market forces, lead to potential efficiency gains, stimulate technical innovations, and support economic investments (Geman, 2005; Weron, 2006). After the pioneering liberalization of Chile in 1982, the European countries started their own deregulation process (Weron, 2006). In 1990, the United Kingdom began to reform its electricity market, and in 1992 the Nordic markets followed a similar path. The number of liberalized markets in Europe has since been increasing as the European Union has been pushing towards deregulation.
This large wave of liberalizations across Europe and around the world has led to both positive and negative impacts in terms of price and investment behaviour. According to Weron (2008), the deregulation of electricity markets has generally decreased the price level (the increased taxes reversed the effect). However, according to Geman (2005), the price effect is ambiguous. For example, the UK and the French markets belong to the electricity markets with the lowest production costs. Interesting is however, while the UK has one of the most deregulated market, the French market is strongly regulated. Mixed effects have also been observed in the investment behaviour after the liberalization. On the one hand, the liberalization wave resulted in a reduction of overcapacities and increased efficiencies (Weron, 2008). Before the liberalization, the producers were able to pass the production costs directly to the end-consumers (Deng & Oren, 2006). Since in this framework, the producers had no incentive to keep low production costs, over-investments and inefficiencies occurred. In a deregulated market, the competitive environment puts pressure on the supplier to produce efficiently. This shifts the investment risk from the consumer to the producer (Deng & Oren, 2006). On the other hand, the competitive environment that came along with the liberalization lured companies to invest in facilities that could be built in a short time (e.g. gas-fuelled plants) despite the unfavourable energy source (Weron, 2008).
In the hope to profit from the benefits, Switzerland has joined the liberalization trend and is currently deregulating the market. The process of deregulation started in 2003, when the federal court claimed the regulated system to contradict antitrust laws (VGE, 2008). The plan is to have an open market in 2014. The deregulation is taking place in two phases. In a first step, large power consumers with a consumption of over 100 GWh can change their power supplier by the end of 2008. Smaller clients will benefit from improved price transparency. In
4However, not only the deregulation, but also other factors played a major role in the California crises (Weron,
2008).
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a second step, the smaller clients will similarly be able to select their power supplier by 2014. Similar to other countries, Switzerland will keep certain regulations and only introduce restricted market forces. Since electricity is a basic necessity for everyday living, its provision will not be completely left to the market forces.5
Another effect of the global deregulation trend was the creation of electricity exchanges where electricity can be traded6. According to Weron (2008), these exchanges represent a common factor for all successful markets, as they provide a formal price quotation mechanism. In contrast to other countries, Switzerland is not likely to have its own power exchange. However, the EEX in Germany and the EXAA in Austria have launched a Swiss segment, where most of the Swiss suppliers and distributors are trading (EEX, 2008, EXAA, 2008). As a measurement of the market prices of the Swiss electricity prices, there are two main indices. Since 1999, there exists a price index for Swiss energy prices (SWEP), which is calculated by Dow Jones indices services (BKW, 2008). Since 2006, the European Energy Exchange (EEX) is also calculating a price index (Swissix) (EEX, 2008). This index shows the spot market clearing price every day.
