Title: Explaining the risk behind futures prices with distortion functions
Authors: Daniela Escobar - London School of Economics (United Kingdom) [presenting]
Florentina Paraschiv - Norwegian University of Science and Technology NTNU (Norway)
Michael Schuerle - University of St Gallen (Switzerland)
Abstract: It is well-known that the classical arbitrage-based methods are not applicable for pricing electricity derivatives in the same way as for other commodities since electricity cannot be stored. Consequently, futures valuation do not follow a general rule. We fill the gap between spot prices and futures prices with three different premia: the distortion premium, an information premium and an ambiguity premium. Firstly, distortion functions serve to explain the different risk preferences of consumers and producers when trading these futures. Besides, we make the distortion premium applicable for pricing electricity futures, by including negative risk premia. Secondly, it has been established that futures prices contain more information than the one provided by the spot market. Therefore, we include a correction parameter to quantify this lack of information and define an information premium. Lastly, we include an ambiguity premium which is measured in terms of the Wasserstein distance. The goal is to identify these three different components from observed prices and shed some light on the pricing mechanism of futures and their risk premia. For our results, we propose a regime-switching model for the spot prices. Overall, this methodology allows the identification of distortion functions and a correction factor under model ambiguity.