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Market-consistent modeling for cap-and-trade schemes and application to option pricing

Barrieu, Pauline and Fehr, Max (2014) Market-consistent modeling for cap-and-trade schemes and application to option pricing. Operations Research, 62 (2). pp. 234-249. ISSN 0030-364X

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Abstract

In this paper we refer to the requirement for industrialized countries to reach a domestic target for greenhouse emissions, as ratified in the Kyoto Protocol, and propose a market-consistent model of futures price dynamics for cap-and-trade schemes designed in the spirit of the European Union Emissions Trading Scheme (EU ETS). Historical price dynamics for the EU ETS suggest that both European emission allowance (EUA) and certified emission reduction (CER) certificates, generated by a nondomestic offset mechanism, are significantly related. We use an equilibrium framework to demonstrate that compliance regulation singles out special price dynamics. Based on this result, we propose an arbitrage-free model and apply it to the pricing of spread options between EUAs and CERs.©

Item Type: Article
Official URL: http://pubsonline.informs.org/journal/opre
Additional Information: © 2014 INFORMS
Library of Congress subject classification: H Social Sciences > HA Statistics
Sets: Departments > Statistics
Research centres and groups > Centre for the Analysis of Time Series (CATS)
Research centres and groups > Risk and Stochastics Group
Rights: http://www.lse.ac.uk/library/usingTheLibrary/academicSupport/OA/depositYourResearch.aspx
Date Deposited: 13 May 2014 10:56
URL: http://eprints.lse.ac.uk/56750/

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