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 Marketing Strategy Unplugged by David Black  MBAs with a Mission by Brook Raflo Thinking inside the Box by Nicholas Shreiber, Guest Columnist |
Inquiring Minds  Professor of Finance Hendrik Bessembinder's current research focuses on linkages between stock market structure and trading costs and on pricing and risk management in wholesale electricity markets. In this new column, Goizueta Magazine asks him to comment on the implications of his research. He completed his doctorate in finance at the University of Washington in 1986. Because of its volatility, electricity is popular in the derivatives market. It's a risky business, isn't it? Yes, and that naturally leads companies to look for instruments to reduce their risk, which is where my research comes in. The simplest risk-management contract is a forward contract, where we agree now to deliver electricity later but fix the price now. In the world of finance, there are some well-established models for how forward prices should be set, but the problem is that the models that apply in other markets are all based on the idea that somebody can buy the good, store it, and deliver it later. So those models don't apply because you can't store electricity? That's right. Standard textbook models for pricing electricity don't work. So we're starting from ground zero. We're trying to decide what's a fair price for delivering electricity later. What's new and different about this is that our model says there will be a premium-mathematically, it's for the skew in the prices. But, more intuitively, there's a premium in the forward price for the possibility that the spot electricity price might take a big jump, it might spike up. Nobody wants to be in a contract where they've said they'll deliver electricity at a fixed price when there's a possibility the price could spike up to ten, twenty, thirty times that. As a consequence, to get them to agree to deliver it at a fixed price, the fixed price has to be bid up. There's a premium in the forward price for electricity and, in particular, it's there in the summer because that's when we have the possibility of the big price spikes. What does this mean for an average power company? If they want to cover themselves by buying electricity in the forward markets, they have to pay a premium to cover the possibility of these price spikes. And that's where all the mathematical equations lead? Basically, they lead to it as a theoretical implication. Then we go to the data, and-surprise, surprise-it really works that way. Allison Sherriffs 
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