Structured Products on Electricity

The Swiss electricity market has been facing structural changes in recent years due to market deregulation activities. This development has been accompanied by the emergence of spot markets where electricity is traded between producer and purchaser. Since the price charged to the end-customer turns out to be more exposed to market prices of electricity, the need for
derivatives with a risk management purpose arises. A more recent asset class such as structured products may be used as a risk management tool. This paper focuses on the pricing of various structured products with the Swiss energy price indices as an underlying.
Since electricity has particular features that result in a peculiar stochastic process, the pricing of electricity derivatives cannot rely on traditional pricing formulas that have been developed for equity or commodity underlyings. Rather, there is a need for a dynamic model that captures the unique characteristics of electricity. In this paper, a new jump diffusion process is
proposed and estimated that is able to incorporate the Swiss electricity price properties.
Building on this model, a Monte Carlo simulation is applied that allows one to price differing electricity derivatives that are embedded in structured products. Using the option pricing results, the feasibility and attractiveness of a defined range of structured products is investigated. In order to include the special properties of electricity, new structured products
are developed that are more appropriate as risk management tools. One of the main contributions of this paper is the practical approach of how to price structured products.
Keywords: Electricity, SWEP, Swissix, Structured Products, Monte Carlo, Jump
Diffusion, Derivatives pricing