The thesis aimed to answer the following research question:
“Are derivative pricing premiums present in the Nordic power market, and how do these influence hedging strategies?”
By methodically answering the six sub-questions presented in Chapter 3. Approach to research question, readers were first provided with the theoretical framework required for the thesis investigations. Both option- and futures pricing theory were assessed, and volatility- and forward premiums defined, which later became the pricing premiums subject to investigation. Additionally, the unbiased forward rate hypothesis was reviewed, providing the readers with an understanding of how regressions can be used to test whether significant systematic forward premiums were present in the market.
Furthermore, considering the complexity of the Nordic power market, readers were provided with knowledge about market dynamics and -structure, products, and concepts. Chapter 7. Definitions outlined the importance of system operators being market operators striving to fulfill electricity area demands, resulting in physical electricity being priced using the concept of Locational Marginal Pricing.
Readers were introduced to Nord Pool and Nasdaq, the two market participants responsible for physical electricity- and derivatives trading on the Nordic power market. Despite Nordic power derivatives being traded through Nasdaq, quoting of the system price is performed by Nord Pool and this is the reference price for all derivatives on Nasdaq.
In Chapter 9. Descriptive statistics, analyses of both the system price and futures prices were performed, resulting in the first quantitative indication of a potential seasonality pattern for premiums on the Nordic power market. The system price was observed consistently higher during winters and summers, and lower during falls and springs. Using findings from interviews and past research, different futures indices were created to better represent the development of futures prices and their correlation with the underlying system price. As should be expected, statistical characteristics similar to the system price were observed for the indices, indicating that futures may be unbiased predictors of futures system prices.
115 The research question in this thesis was designed such that market participants could benefit from related findings. Considering that both options and futures are commonly used in hedging, and that participants in the market need larger volumes of contracts to hedge their positions, Chapter 8.
Liquidity analysis found derivatives’ liquidity to be the main obstacle for derivatives being suitable for hedging. Based on qualitative and quantitative findings, options were excluded from further analyses due to poor liquidity. Chapter 11. Discussion: Where are the options? discussed potential explanations for the decreasing liquidity, and in doing so compared the Nordic power market with other commodity markets. Furthermore, the thesis analyzed historic liquidity on futures with different baseloads and concluded that weekly and monthly futures were the futures with highest liquidity within the data period.
With options excluded from premium investigations, Chapter 10. Forward premium analysis focused solely on forward premiums on weekly and monthly futures contracts. The reader was presented with findings from historical forward premium calculations on the futures indices presented in Chapter 9.
Descriptive statistics. Historical forward premiums were found in all monthly- and weekly futures indices, except from Index3 – Months and Index1 – Weeks, indicating that derivative pricing premiums were present on the Nordic power market. Further investigation found winter (spring) to be the season with highest (lowest) historical forward premium.
Testing the significance of the historical forward premiums entailed the use of the unbiased forward rate hypothesis (UFH) presented in Chapter 6. Theories. Regressing the system price with futures indices as explanatory variables generated evidences against the UFH null hypothesis, stating that systematic forward premium (𝛼) is equal to zero. Conducting the same regression on logarithmic transformed variables provided evidence against the UFH null hypothesis on weekly indices and on Index3 – Months. Furthermore, seasonal UFH-regressions were conducted to investigate the presence of significant systematic forward premiums within different seasons. Its findings may be directly related to historical forward premium findings as winter was the only season providing evidence against the UFH null hypothesis for both weekly and monthly futures. Spring rejected the null hypothesis for weekly futures.
116 In Chapter 12. Hedging the reader was introduced to the concept of risk mitigation in relation to participants on the Nordic power market. The hedging optimization was divided into three sections:
12.3 Hedging for power producers, 12.4 Hedging for power suppliers, and 12.5 ‘Hedging’ for speculators.
Hedging strategies for power suppliers and -producers were designed to exploit the findings about present seasonal forward premiums on the Nordic power market. The strategies were tested ex-post with the objective of optimizing strategies based on different risk criteria; standard deviation, Value at Risk, and average cost/return. The speculator was included in the chapter as findings from interviews indicated collaborations existing between hedging- and trading departments in the market. Thus, optimal portfolios for mean-variance optimizing speculators were presented.
The introductory chapters, Chapter 8, 9 and 10 described and analysed the first part of the research question:
These findings were further used to answer the second part of the research question in Chapter 12:
“Are derivative pricing premiums present in the Nordic power market, and how do these influence hedging strategies?”
The analysis concluded that derivative pricing premiums have been present historically on weekly and monthly futures. Furthermore, systematic forward premiums on weekly and monthly futures were found significant, but with seasonal dissimilarities.
“Are derivative pricing premiums present in the Nordic power market, and how do these influence hedging strategies?”
Findings about present forward premiums impact both hedgers and speculators in the market as it is possible for market participants to exploit price differences on futures and the system price. As a result of the present forward premium, market participants need to assess their willingness to pay a premium for hedging positions in seasons, such as winter, with higher forward premiums.
Participants may also be able to exploit the forward premium findings by constructing optimal hedging portfolios using the mean-variance framework and a preferred risk measure goal. In other words, this thesis concludes that both power producers and -suppliers should optimize their hedging strategies by considering the presence of pricing premiums on the Nordic power market and the seasonal dissimilarities.
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