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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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    $\begingroup$ Regardless of the underlying, the derivative, which is a traded asset, should be discounted using the 'risk-free' rate. $\endgroup$
    – user34971
    Jan 7, 2022 at 11:26
  • $\begingroup$ Could you elaborate a bit more why that's the case? Or point to a reference that discusses it in detail. I understand why that's the case when a hedging portfolio exists, but I am not sure it does exist for power. $\endgroup$
    – KT8
    Jan 7, 2022 at 11:36
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    $\begingroup$ The hedging portfolio does exist if you assume derivatives are traded: the hedging portfolio for a derivative is the money market account and another derivative on the same underlying asset! Let me know if this is still unclear and I'll give you a poor man's derivation why the drift of the derivative is risk-free rate. $\endgroup$
    – user34971
    Jan 7, 2022 at 13:09
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    $\begingroup$ This may disappoint you, but the strategy would be to an offsetting position in another future/forward. It's the same with the VIX index: VIX futures are not hedged by buying the underlying VIX index (which is not possible / not traded), but by offsetting positions in other VIX derivatives. If your question is how do you price derivatives when there are no other derivatives yet, that is a different question. Then you would really have to specify your 'market price of risk', but it still doesn't change the fact that the derivative would be the risk-neutral discounted payoff. $\endgroup$
    – user34971
    Jan 7, 2022 at 13:30
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    $\begingroup$ This may help, from page 30 onwards where Bjork starts discussing options on short rates and the term structure equation, which is similar to your case (the underlying is not traded): staff.fnwi.uva.nl/p.j.c.spreij/winterschool/1slidesBjork1.pdf $\endgroup$
    – user34971
    Jan 7, 2022 at 13:38

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