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Price Forecasting in Spot Markets: Hidden Risks in Single-Part Bidding

Fortnightly Magazine - October 15 1998

these pricing models yield the volatility estimates required for option pricing techniques, such as the famous Black-Scholes model or stochastic dynamic programming. This is an exciting area of current research and there are important techniques available.

In the current state of market development, however, statistical techniques have limited application to asset valuation. Forward curves are unreliable for longer periods of time; volatilities and correlations are unstable. For the brave-hearted, or those who are thoroughly disgusted with fundamental valuation methods, the statistical models are an alternative. Over time, as the markets broaden and liquidity deepens, they will get better. But right now, price forecast users in the asset valuation market are probably stuck with production simulation products. For these users, beware.

Edward P. Kahn is a vice president in the San Francisco office of National Economic Research Associates Inc. Over the previous decade he has held positions as senior scientist in the energy and environment division of the Lawrence Berkeley Laboratory, leader of LBL's utility policy and planning group, and co-director of the Program on Workable Energy Regulation (POWER) at the University of California Energy Institute, also located in Berkeley, Calif.

1 See, for example, D. Pilipovic, Energy Risk: Valuing and Managing Energy Derivatives, 1998, for some persuasive evidence.

2 The best modern papers in this genre are: For Cournot, S. Borenstein and J. Bushnell, "An Empirical Analysis of the Potential for Market Power in California's Electricity Industry," University of California working paper, 1996, and J. Bushnell, "Water and Power: Hydroelectric Resources in the Era of Competition in the Western US," 1998; For SFE, R. Green and D. Newbery, "Competition in the British Electricity Spot Market," Journal of Political Economy, 100(5) 929-953, 1992 and R. Green, "Increasing Competition in the British Electricity Spot Market," Journal of Industrial Economics, 44(2) 205-216, 1996.

3 See D. Pilipovic, note 1, M. Hsu, "Spark Spread Options are Hot!" The Electricity Journal, v. 11, no. 2 (1998) 6-18 and V. Kaminski, "The Challenge of Pricing and Risk Managing Electricity Derivatives," The US Power Market, 1997.

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