Abstract
This paper proposes a regime-switching model with time-dependent transition probabilities. Electricity prices are divided into “base” and “spike” regimes. The base regime is characterised by a mean-reversion diffusion. The spike regime is a shift of the mean-reverting diffusion from the base regime for different parameters. With the daily spot electricity prices in the PJM market, we find that the probability of staying in the base regime is much larger than in the spike regime. As expected, the probability of transiting into the spike regime is higher in winter and summer. We then derive a closed-form pricing formula for the futures pricing and investigate the stochastic risk premia under each regime. The risk premium under the base regime is negatively correlated with the price level, while the risk premium on spikes is positively correlated with the size of the spike.
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