Equilibrium-Based Black-Scholes Option Pricing in Electricity Markets

Abstract

In this article, a new model for option pricing using the Black–Scholes option pricing method under equilibrium of the option and day-ahead markets is presented. To analyze the performance of the Black–Scholes option pricing method in financial electricity markets, the model is compared with the equilibrium option pricing (Eq-Pr) model. To this end, first, the option pricing curves of the above-mentioned models on the option contract area (OCA) of the financial electricity market are drawn. Here, the option pricing curve means the computed premium price versus strike price, and the OCA is the area of the premium price-strike price plane in which both option buyers and sellers are willing to conclude option contracts. Then, overlap of the Black–Scholes option pricing curve with the OCA and its distance to Eq-Pr curve is assessed. The controversy among researchers about the applicability of the Black–Scholes option pricing in financial electricity markets is assessed by applying the proposed models to a test power system and the conditions in which Black–Scholes option pricing works are discussed.