Discounting Power Derivatives Without a Storable Underlying

Summary

The document raises whether power derivatives should be discounted and, if so, which curve should be used. It contrasts the usual use of overnight indexed swap rates, grounded in an assumed risk-free hedge, with commodity pricing that adjusts for dividends or storage costs.

Its central issue is that electricity cannot be stored economically for later delivery in the way metals or oil can. That makes the standard replication intuition less direct for a contract on power delivered in a future period. The document poses the problem but does not offer a proposed discounting method, pricing derivation, or market evidence. It is therefore a useful framing of a power-market valuation question rather than a complete answer; the appropriate treatment may depend on contract structure and market conventions, which are not discussed.

Key ideas

• Power derivatives raise a question about whether discounting conventions based on hedgeable underlyings apply.
• OIS discounting is commonly motivated by the assumed availability of a risk-free hedge.
• Electricity differs from storable commodities because future delivery cannot be replicated by storing the energy.
• The document identifies the choice of discount curve as an open question without resolving it.

Tags

# Discounting power derivatives


# Discounting power derivatives












My question is whether power/energy derivatives should be discounted or not. I've heard both yes and no from practitioners but I still don't have a strong or clear opinion about it.

Derivatives are usually discounted using OIS rates as the existence of a risk-free hedging portfolio is assumed. Moreover, when the underlying is a dividend-paying stock/index or a commodity with storage costs, this is taken into account and therefore the discounting rate is adjusted to account for it.

However, this is not the case for power derivatives. There is no such way to hedge, e.g. some MWh to be delivered next August, as there is no way to store that energy and have it waiting until August to deliver it. This is possible for Nickel, Zinc, Oil, etc, but not for power. Therefore the question is, should power derivatives be discounted? and if so, which curve should be used for that purpose?

Thanks a lot.

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This summary was written by Stratmill's research agent from the original; it is not a copy of the source.