Three Essays on Electricity Spot and Financial Derivative Prices at the Nordic Power Exchange

Essay I examines the market efficiency issues at the Nord Pool power exchange in the September 1995 – July 2002 period. A unique characteristic of this electricity exchange is the high hydropower proportion in the traded electricity; water in the hydro reservoir acting as hydropower inventory therefore plays an important role in the pricing of electricity. Inventory holding and the seasonality of both the supply and demand of hydropower generate interand intra-year autocorrelation in power prices. I present a theoretical discussion on why power price persistence invalidates the applicability of a market efficiency concept based on the random walk theory. To lend support for the theoretical argument, I conduct an empirical investigation consisting of various unit roots and cointegration methods to tackle the data problems/properties, and results show that weekly spot and futures prices are cointegrated. Philips-Loretan’s nonlinear least square is applied in testing the restriction of the coefficient according to the market efficiency hypothesis. The Wald statistic shows that the cointegration vector being (1, -1) is not binding. Residual testing using a Ljung-Box Qstatistic confirms serial correlation. These findings are consistent with the theoretical prediction. Essay II models electricity prices in the context of the Nord Pool power exchange which has a considerable proportion of hydropower supply. Since hydropower is storable in a producer perspective and the system price is a uniform price for all sources of electricity supply, the applicability of the rational expectation competitive commodity storage model to characterize the spot and futures/forward prices is validated. I further show the nonlinearity between futures/forward prices and water reservoir content as inventory. I perform a BDS test (a test for nonlinearity), Hsieh’s third-order moment test (a test that discriminates between different types of nonlinearities) and a nonlinear causality test to portray the nonlinear relationship using short/long maturities contracts. Empirical evidence shows that futures/forward prices are nonlinearly connected with water reservoir content via variance changes, and that the detection of causality varies as maturities change from short to long. These findings provide strong support for the credibility of the arbitrage argument and in a certain case verify the existence of the non-arbitrage condition. Essay III investigates convenience yield behavior at the Nord Pool power exchange given the considerable storable hydropower being traded. Several hypotheses are tested concerning the behavior and determinants of convenience yield from holding hydropower as inventory. The results reveal that 1) convenience yield has a negative relationship with hydro reservoir content as inventory, 2) convenience yield behavior can be statistically explained within a standard financial call option framework and the call option component can explain a large portion of variability in convenience yield, 3) convenience yield varies on both a yearly and a monthly basis, and 4) there is an asymmetry of volatility of convenience yield during high/low hydro inventory periods. Keyword: Nord Pool, market efficiency, cointegration, rational expectation competitive storage model, BDS test, Hsieh’s third order moment test, nonlinear causality, EGARCH, convenience yield, call option. Daniel Deng, Center for Finance, Department of Economics, Goteborg University, SE-40530 Goteborg, Sweden. Tel: +46-31-7734178 Email: Daniel.Deng@handels.gu. se