A Heath-Jarrow-Morton framework for energy markets: a pragmatic approach

Paper: arXiv 2305.01485

Authors: Matteo Gardini, Edoardo Santilli

Abstract

In this article we discuss the application of the Heath-Jarrow-Morton framework Heath et al. [26] to energy markets. The goal of the article is to give a detailed overview of the topic, focusing on practical aspects rather than on theory, which has been widely studied in literature. This work aims to be a guide for practitioners and for all those who deal with the practical issues of this approach to energy market. In particular, we focus on the markets’ structure, model calibration by dimension reduction with Principal Component Analysis (PCA), Monte Carlo simulations and derivatives pricing. As application, we focus on European power and gas markets: we calibrate the model on historical futures quotations, we perform futures and spot simulations and we analyze the results.

Complexity vs Empirical Score

• Math Complexity: 6.5/10
• Empirical Rigor: 7.0/10
• Quadrant: Holy Grail — high math complexity, high empirical rigor

Why this score: The paper provides a solid pragmatic adaptation of the HJM framework to European power and gas markets, using standard PCA for dimension reduction and empirical calibration. While it scores high on mathematical structure and empirical application for practitioners, its conceptual novelty is relatively modest as it relies heavily on established theoretical foundations.

Research Flowchart

  flowchart TD
    A[Goal: Practical HJM Framework for Energy Markets] --> B[Data Input: Historical Futures Quotations<br><i>European Power & Gas</i>]
    B --> C[Dimension Reduction & Calibration<br><i>Principal Component Analysis - PCA</i>]
    C --> D[Simulation & Pricing<br><i>Monte Carlo Futures & Spot Paths</i>]
    D --> E[Outcome: Practical Guide for Derivatives Pricing & Risk Analysis]