Bor Wer DSFM Electricity20080207

Modeling and forecasting electricity forward
prices: A DSFM approach
Szymon Borak
Rafał Weron
CASE-Center for Applied Statistics and Economics ,

Humboldt-Universität zu Berlin
Hugo Steinhaus Center,
Wrocław University of Technology
Motivation 1-1
How can we model the dynamics of the electricity forward curve?
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DSFM: Modeling and forecasting electricity forward prices

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Motivation 1-2
Motivation
The electricity forward curve is a complex object with a

non-trivial structure which exhibits seasonality and extreme
volatility at the short end
Our aim is to model and estimate forward curves for trading,

hedging and risk management
In this context the electricity forward curve acts as a very

high-dimensional state variable
Practice requires a low-dimensional representation of the

curve
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Motivation 1-3
Agenda
1. Motivation X
2. The Nordic power market and the forward curves
3. The Dynamic Semiparametric Factor Model
4. Modelling and forecasting
5. Conclusions
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The Nordic power market 2-1
Wholesale power market structure
Futures and
Forward
Futures,
Markets Financial
Bilateral Forward
and Option
Time
Contracts
Bilateral Markets Day-Ahead Physical delivery
Contracts
Market
Day-Ahead
Intraday
(spot)
Market
Market
Balancing
Balancing
Market
Market
OTC Power Exchange System

Operator
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Supply stack and the market cross
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Supply stack and the market cross cont.
Low
demand
curve
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High
demand
curve
Low
demand
curve
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High
demand
curve
Low
demand
curve
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Seasonality, extreme volatility and spikes
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Futures and forwards at Nord Pool
Futures contracts
Day contracts (Dxx): 24 hours

Week contracts (GUxx): 7 days
Block contracts (GBxx): 4 weeks
Forward contracts
Winter 1 (FWV1xx): January - April

Summer (FWSOxx): May - September
Winter 2 (FWV2xx): October - December
Year (FWYRxx)
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The forward curve and its dynamics
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The Dynamic Semiparametric Factor Model 3-1
The model
The Dynamic Semiparametric Factor Model has the form

L
X
Yt = m0 (Xt ) + Zt,l ml (Xt ) + εt = Z>
t m(Xt ) + εt
l=1
where the data vector Xt has Jt coordinates Xt,j (observations

per day)
m(·) is a tuple of basis functions (m0 , m1 , . . . , mL )>
Zt = (1, Zt,1 , . . . , Zt,L )> is a multivariate time series
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The model cont.
The functions ml reflect the time invariant structure of Yt
m
b l is a nonparametric estimator of ml obtained directly from
the data points Xt,j
The coefficients Zt,l describe the dynamic behavior of the

forward curves
The whole complex system can be modelled through a typical

time series analysis of the estimates Z
bt,l
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Estimation
L
X K
X
Z>
t m(Xt ) = Zt,l al,k ψk (Xt ) = Z>
t Aψ(Xt )
l=0 k=1
ψ(·) = (ψ1 , . . . , ψK )> is a vector of known expansion

functions (e.g. B-splines)
A ∈ R(L+1)×K is a matrix of coefficients
the smoothing parameters L (dimension of the time series; we

use L = 3, . . . , 6) and K (number of series expansion functions;
K = 19 functions on 16 knots) have to be specified in advance
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Estimation cont.
The least squares estimators Z b t = (Z bt,L )> and

bt,0 , ..., Z

A
b= b al,k l=0,...,L;k=1,...,K are obtained from
X Jt n
T X o2
b > Aψ(X
Yt,j − Z b t,j ) w (Xt,j ) = min
t
b t ,A
Z b
t=1 j=1
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Comparison to PCA approach
An alternative way to fit the factor model is to perform (functional)

PCA. First obtain functional representation of functions Yt (x) e.g.
on a regular grid of 1446 points.
Estimate ml and Zt by spectral decomposition of the sample
covariance function
T
X
b x 0 ) = T −1
Σ(x, {Yt (x) − Ȳt (x)}{Yt (x 0 ) − Ȳt (x 0 )}
t=1
−1
PT
where Ȳt (x) = T t=1 Yt (x)
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Identification
If (Z
bt , m)
b are estimates then also
e >Z
(B e −1 m)
bt , B b
define equivalent
estimates.
Here Be is an arbitrary matrix of the
1 0
form Be= , where B is an invertible matrix.
0 B
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Identification cont.
The estimates can be shifted by a constants
L
X L
X
m0 (x) + Zt,l ml (x) = m0 (x) + {(Zt,l − cl )ml (x) + cl ml (x)}
l=1 l=1
XL L
X
new
= m0 (x) + cl ml (x) + Zt,l ml (x)
l=1 l=1
L
X
= m0 (x)new + new
Zt,l ml (x).
l=1
One possible setting for the constants cl is such that Z

bt,l has a zero
mean. 300
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Modelling and forecasting 4-1
The data
Nord Pool futures and forward prices from the period Jan. 4,
1999 – Dec 30, 2004, i.e. 1487 (business) days
A 500 day window is used for calibration
For each day, 1, 5, 25 and 125 day-ahead forward curve

forecasts is computed
This leaves us with 1487 − 500 − 125 = 862 days for which
the procedure (calibration + forecast) is repeated
Both DSFM and PCA approaches for various L (= 3, . . . , 6)

are evaluated
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Sample DSFM and PCA fits

DSFM PCA
2000 2000
1000 1000
0 0
−1000 −1000
−2000 −2000
−3000 −3000
Jan99 Jan00 Jan01 Jan02 Jan99 Jan00 Jan01 Jan02
DSFM PCA
0.1 0.1
0.05 0.05
0 0
−0.05 −0.05
−0.1 −0.1
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In-sample error measure
We compute an absolute in-sample error weighted by the

length of the delivery period for each contract
X
= |Model(Xt,j ) − Yt,j | w (Xt,j )
t,j
where Xt,j are the observed maturities (mid-points of the

delivery periods) j = 1, 2, . . . , Jt for all days t
Yt,j are the respective prices
w are the respective weights
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In-sample errors
16000
PCA(3)
14000 DSFM(3)
12000
10000
PCA(4)
PCA(5)
8000
PCA(6)
DSFM(4)
6000
DSFM(5)
4000
DSFM(6)
2000
0
0 200 400 600 800 1000
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In-sample error statistics

Quantiles of the in−sample error
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14000
12000
10000
8000
6000
4000
2000
0
DSFM(3) DSFM(4) DSFM(5) DSFM(6) PCA(3) PCA(4) PCA(5) PCA(6)
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Forecasting setup
For a 500 day window the DSFM and PCA models (with
L = 3, . . . , 6 factors) are calibrated
For l = 2, 3, Z
bt,l generally exhibit a seasonal pattern
A sinusoidal function gl (t) = Al sin(Bl t + Cl ) is fitted and

removed yielding Zet,2 , Z
et,3
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Forecasting models
Random Walk (RW): forward (futures) prices from day t
YT∗ +h (x) = YT (x)
Trend update (STr1 for DSFM and PTr1 for PCA): the
sinusoidal trend gl is forecasted for l = 2, 3 and added to the
forward price forecast
3
X
YT∗ +h (x) = YT (x) + b l (x) {b
m gl (T + h) − gbl (T )} .
l=2
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Forecasting models cont.
Trend update from model (STr2, PTr2): Like ‘Trend update’,

but model instead of the true curve
L
X 3
X
YT∗ +h (x) = Z
bT ,l m
b l (x) + b l (x) {b
m gl (T + h) − gbl (T )}
l=0 l=2
XL X3
= Z
eT ,l m
b l (x) + m gl (T + h),
b l (x)b
l=0 l=2
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Forecasting models cont.
Full forecast with AR(2) time series (STS, PTS): Additionally

includes AR(2) forecasts of all coefficient time series
Z
et,1 , Z
et,2 , . . . , Z
et,L
L
X 3
X
YT∗ +h (x) = e∗
Z T +h,l m
b l (x) + m gl (T + h).
b l (x)b
l=0 l=2
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One day-ahead forecasts
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5 days-ahead forecasts
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Forecasts for different L
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Forecasts different time horizon
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Conclusions 5-1
Conclusions
The electricity forward curve is a complex object with a

non-trivial structure
Both approaches allow for dimension reduction
The DSFM offers superior in-sample performance
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Conclusions 5-2
Conclusions cont.
DSFM-based models are comparable to their PCA-based

counterparts for short and worse for long term predictions
The current forward curve (RW model) is on average the best

predictor of the curve in the next few days, it is inferior for
long term forecasts
Larger number of basis functions (larger L) improves short

term forecasts but leads to increased variance of the longer
term forecasts
Better in-sample fit does not imply superior out-off-sample fit.
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Conclusions 5-3
References
Borak, S., Härdle, W., Mammen, E., Park, B.U. (2007)

Time Series Modelling with Semiparametric Factor Dynamics, SFB
649 Discussion Paper 2007-023.
Koekebakker, S., Ollmar, F. (2005)
Forward curve dynamics in the Nordic electricity market, Managerial
Finance 31: 74–95.
Weron, R. (2006)
Modeling and Forecasting Electricity Loads and Prices:
A Statistical Approach, Wiley, Chichester, 2006.
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Modeling and forecasting electricity forward

prices: A DSFM approach

CASE-Center for Applied Statistics and Economics ,

How can we model the dynamics of the electricity forward curve?

DSFM: Modeling and forecasting electricity forward prices

The electricity forward curve is a complex object with a

Our aim is to model and estimate forward curves for trading,

In this context the electricity forward curve acts as a very

Practice requires a low-dimensional representation of the

DSFM: Modeling and forecasting electricity forward prices

2. The Nordic power market and the forward curves

3. The Dynamic Semiparametric Factor Model

4. Modelling and forecasting

DSFM: Modeling and forecasting electricity forward prices

Wholesale power market structure

OTC Power Exchange System

DSFM: Modeling and forecasting electricity forward prices

Supply stack and the market cross

DSFM: Modeling and forecasting electricity forward prices

Supply stack and the market cross cont.

DSFM: Modeling and forecasting electricity forward prices

Supply stack and the market cross cont.

DSFM: Modeling and forecasting electricity forward prices

Supply stack and the market cross cont.

DSFM: Modeling and forecasting electricity forward prices

Seasonality, extreme volatility and spikes

DSFM: Modeling and forecasting electricity forward prices

Futures and forwards at Nord Pool

Day contracts (Dxx): 24 hours

Winter 1 (FWV1xx): January - April

DSFM: Modeling and forecasting electricity forward prices

The forward curve and its dynamics

DSFM: Modeling and forecasting electricity forward prices

The Dynamic Semiparametric Factor Model has the form

where the data vector Xt has Jt coordinates Xt,j (observations

m(·) is a tuple of basis functions (m0 , m1 , . . . , mL )>

Zt = (1, Zt,1 , . . . , Zt,L )> is a multivariate time series

DSFM: Modeling and forecasting electricity forward prices

The model cont.

The functions ml reflect the time invariant structure of Yt

The coefficients Zt,l describe the dynamic behavior of the

The whole complex system can be modelled through a typical

DSFM: Modeling and forecasting electricity forward prices

ψ(·) = (ψ1 , . . . , ψK )> is a vector of known expansion

A ∈ R(L+1)×K is a matrix of coefficients

the smoothing parameters L (dimension of the time series; we

DSFM: Modeling and forecasting electricity forward prices

The least squares estimators Z b t = (Z bt,L )> and

DSFM: Modeling and forecasting electricity forward prices

Comparison to PCA approach

An alternative way to fit the factor model is to perform (functional)

DSFM: Modeling and forecasting electricity forward prices

DSFM: Modeling and forecasting electricity forward prices

One possible setting for the constants cl is such that Z

DSFM: Modeling and forecasting electricity forward prices

A 500 day window is used for calibration

For each day, 1, 5, 25 and 125 day-ahead forward curve

Both DSFM and PCA approaches for various L (= 3, . . . , 6)

DSFM: Modeling and forecasting electricity forward prices

Sample DSFM and PCA fits

DSFM: Modeling and forecasting electricity forward prices

In-sample error measure

We compute an absolute in-sample error weighted by the

where Xt,j are the observed maturities (mid-points of the