Abstract
In this paper we provide a framework that explains how the market risk premium, defined as the difference between forward prices and spot forecasts, depends on the risk preferences of market players and the interaction between buyers and sellers. In commodities markets this premium is an important indicator of the behavior of buyers and sellers and their views on the market spanning between short-term and long-term horizons. We show that under certain assumptions it is possible to derive explicit solutions that link levels of risk aversion and market power with market prices of risk and the market risk premium. We apply our model to the German electricity market and show that the market risk premium exhibits a term structure which can be explained by the combination of two factors. Firstly, the levels of risk aversion of buyers and sellers, and secondly, how the market power of producers, relative to that of buyers, affects forward prices with different delivery periods.
Highlights
Commodities are a very different asset class from the more traditional classes of traded assets such as equities and bonds
In this article we address the important question of what gives rise to the market risk premium
We provide a framework that allows us to explain how risk preferences of market players explain the sign and magnitude of the market risk premium across different forward contract maturities
Summary
Commodities are a very different asset class from the more traditional classes of traded assets such as equities and bonds. In electricity and gas markets one normally observes that, for ‘long’ dated forward contracts, markets are in backwardation and for ‘shorter’ maturities the market is in contango (Cartea and Figueroa, 2005; Cartea and Williams, 2007) Another quantity of importance that relates forward and expected spot prices is the market risk premium or forward bias p(t, T). Consumers (which might be intermediaries and/or use the commodity in their production process) have an incentive to hedge their positions in the market by contracting forwards that help diversify their risks. We determine the forward price that makes the agents indifferent between the forward and spot market and, second, we discuss how the relative willingness of producers and consumers to hedge their exposures determines market clearing prices. We determine the forward price that makes the producer indifferent between the two alternatives, denoted by
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