Projecting and Forecasting the Latent Volatility for the Nasdaq OMX Nordic/Baltic Financial Electricity Market Applying Stochastic Volatility Market Characteristics

Abstract

In this empirical study, multifactor stochastic volatility models for the financial Nordic/Baltic power markets are developed, implemented, and analyzed. Stochastic volatility projections are the primary aim, followed by volatility forecasts and market repercussions. The research provides a functional variant of the conditional distribution (f(x|y)) based on conditional moments and a long-simulated state vector realization (MCMC-GMM) that is evaluated on observed data (a non-linear Kalman Filter) and applicable for step-forward volatility forecasts. For front year and quarter financial electricity contracts, the SV model creates two mean-reverting factors: one persistent and slowly moving component and one choppy, rapidly moving component. According to these factors, static volatility predictions with optimum and generous lags have a Theil covariance percentage of well over 97 percent for the front year contracts and 86 percent for the front quarter contracts. The volatility visibility and its associated static forecasts improve market transparency and will eventually make diversification and risk management easier to implement.