Determinants of forward risk premium : an empirical analysis of the spanish electricity market

Abstract

Motivation Significant ex-post forward risk premium (the difference between forward and realized spot prices) has been found existing in most of the electricity markets. It is still not clear that if the forward risk premium fully represents compensation to financial market participants for bearing systematic risk, or in fact it contains information not used by market agents which indicates inefficiency in the forward markets. Hence it is very necessary and of significance to study the forward price formation, and further to discover the determinants of the ex-post risk premium associated in forward prices. Research questions The main research question is: What are the main determinants of ex-post forward risk premium in the Spanish electricity market? The sub-research questions are:  What are the characteristics of ex-post forward risk premium?  How the risk premium is related to fundamental measures of risks faced by market participates?  How do supply and demand shocks affect risk assessments and market outcomes?  What is the effect of regulatory provisions on forward market and forward risk premium?  What is the effect of speculative and hedging activities on future-spot bias?  What are the implications for the performance of electricity forward markets? Theory The thesis is based on the hedging pressure theory developed by Keynes (1930) that the future contract acts as an instrument for market agents to hedge price risk. The difference between future and expected future prices, namely the ex-ante forward risk premium, is the compensation required by the agent who is willing to bear the spot price risk. Ex-post risk premium as the difference between the future price and the realized spot price at maturity, is an unbiased estimate of the ex-ante risk premium under the assumption that agents form rational forecasts. Bessembinder and Lemmon (2002) develop an equilibrium model for electricity forward prices. Their model implies that the ex-ante forward premium is negatively related to the variance of the spot prices, but positively related to the skewness of spot prices. Determinants of forward risk premium: An empirical analysis of the Spanish electricity market ii Master in the Electric Power Industry (MEPI) 2014-2015 Methodology In this study, future prices for electricity monthly base-load future contracts settled on the last trading day covering delivery time from January 2010 to March 2015 in OMIP, and monthly average spot prices from OMIE were used to calculate the ex-post forward risk premium. We proposed a comprehensive multifactor propositional framework so as to discover the determinants of forward risk premium. It included fundamental influences, behavioral effects, dynamic effects, market hedging, speculative activities and liquidity, regulatory instruments, and shock effects. In addition an econometric model based regression analysis was used to quantify the influence of these determinants on forward risk premium. Results Significant positive forward risk premium is found in the Spanish forward markets. The regression results suggest that market agents follow adaptive expectation formation rather than rational expectation. Moreover, the risk premium is positively influenced by regulated auctions, margin shocks, spot price volatility, and negatively influenced by basis. Conclusion  The variance of daily spot prices during the trading month positively influences the ex-post risk premium. It indicates that there is more hedging pressure from retailers with risk aversion to spot price volatility. The spot price variance during trading month can be seen as the fundamental risk assessment by market participants who form adaptive price expectation.  Increasing margin shocks leads to lower realized spot prices, and higher risk premium. Margin shocks represent the misjudgment of future supply and demand conditions by market agents.  CESUR and OMIP call auctions increased forward prices and forward risk premium during the study period.  The average positive 10% relative ex-post forward risk premium indicates that future markets results are largely determined by retailers.  The basis is used as a dynamic estimator of risk premium which captures the links between current spot prices and forward prices, in turn confirming that market agents follow adaptive price formation.  The residual of the regression model does not confirm normal distribution, implying that there is still information not used by the market agents to form forward prices. Hence market inefficiency cannot be ruled out still.