Does the Black- Scholes formula work for electricity markets? A nonparametric approach

Abstract

Despite the high volatilities recorded for electricity prices, there seems to be little demand´for options on electricity. One reason for the disinterest in electricity options could arise from uncertainty about how to price these options. This study uses recent econometric advances to nonparametrically estimate correct prices for electricity options and compare these to the Black-Scholes prices. The main finding is that although the nonparametric estimates deviate significantly from the Black-Scholes prices, it would be difficult to find an alternative parametric model that performs better. Thus, from a practical viewpoint, the Black-Scholes prices appear to be the best available.