Estimating the Commodity Market Price of Risk for Energy Prices∗

The purpose of this paper is to determine the magnitude and sign of the commodity “market price of risk ” (MPR) for electricity and natural-gas prices. This MPR variable determines whether forward prices in energy are upward- or downward-biased predictors of future expected spot prices. We evaluate that risk premium by estimating the drift term in spot and futures prices. In futures prices, we explicitly account for the Samuelson hypothesis “term structure of volatility.” In spot prices of electricity, we examine the relationship between Day-Ahead Prices and Real-Time Prices. The results have implications for understanding the relationship between energy markets and other physical and financial markets, for incorporating the risk premium in making informed hedging decisions in industry, and for relating futures prices to the forecast prices produced by industry. ∗Acknowledgments: The authors acknowledge the helpful comments and suggestions of seminar participants at the University of Texas at Austin. The methods and conclusions of the paper, and any errors therein, are the sole responsibility of the authors