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In the electricity sector, what should be the shape of the volatility smile?

a behavior similar to other commodities with a convex curve, decreasing first and then growing to the initial level.

or

a volatility skew with volatilities elevated for higher strike prices ??

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2 Answers 2

This article discusses the problem on the German electricity market.

They arrive at the following conclusion:"When the B&S model is used to calculate implied volatilities one often obtain different numbers for different values of K and T. In particular, a "smile" or "smirk" shape is often observed in the plot of implied volatility versus strike price. Implied volatility tends to increase with maturity time, but is often larger for options with very short maturities. This is due to the increase in price that sometimes occurs when options are close to maturity as the price and the payoff converge."

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basically that means that possibly we can find both behaviors (correct me if I'm wrong). This question arose due to the impact of the interest rate on the shape obtained. For example using r=0.2% (an unnusual value but close to our economic reality) instead of r=2%. –  Joao Serafim Aug 11 '13 at 3:00
    
The volatility for electricity market has what is called forward skew. It decreases first but increases by more for higher strikes. This reflects the concern of the market with regard to high jumps in the price of this commodity. –  KAT Aug 11 '13 at 8:34
    
Since in BS model (I guess this is what you use) the interest rate is deemed constant, changing the interest rate and looking at the volatility evolution doesn't make too much sense. The model assumes that the market has a reference interest rate and the patterns in volatility are due to either the fact that the market gives higher probabilities to jumps in the price or that there is a higher demand for the options with higher strikes. –  KAT Aug 11 '13 at 8:53

This is a great question that I actually had when I worked on the trading floor at this large energy company that traded power and other energy commodities.

Electricity has a volatility skew to the upside. So vol for OTM Calls/Deep ITM Puts trades at a premium. Mainly because prices have a tendency to shoot to the upside when load exceeds base demand until new supply comes online to absorb the new demand.

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