Models for option pricing in energy markets

Interconnectors, which are high-voltage cables linking neighboring electricity systems, facilitate efficient power exchange across regions, balancing supply and demand while leveraging renewable resources. They help harmonize energy prices, promoting economic welfare, but technical constraints can lead to congestion and price disparities, resulting in inefficiencies. To manage price fluctuations arising from these challenges, financial derivatives, partic- ularly spread options, are employed. This work discusses two models for pricing spread options based on the interconnected electricity markets of Spain and France. The first model utilizes Margrabe’s formula, while the second is designed to model the spread be- tween power spot prices through mean-reverting processes. Subsequently, option prices are computed based on the prices generated from this spread model. A new approach refines the spread model by incorporating the price difference between power futures as an input. Additionally, a trading strategy based on this new approach is developed, aiming to capi- talize on auction pricing inefficiencies.