Forward price and fitting of electricity Nord Pool market under regime-switching two-factor model

Abstract

Jump in electricity prices is often due to shock in electricity demand or shock in existing electricity supplies, which can be caused by sudden changes in temperature or production and system failure. Since jumps in electricity dynamics are directly related to the regime switch, we model them via the chain itself and consider a regime switching model for electricity spot price dynamic. Next, we determine an equivalent measure by Esscher transform and through it we evaluate the electricity forwards and risk premium. We apply expectation maximization algorithm to estimate parameters of the model. Furthermore, we use the real data of Nord Pool market to calibration of the proposed model. Using the characteristic function of model, we obtain a closed-form for forward contracts of Nord Pool market. Finally, we provide forward surfaces which show the months, quarters and seasons-ahead prices.