Valuation and hedging of European contingent claims on power with spikes: a non-Markovian approach

A new approach to modeling spikes in power prices proposed earlier by the author is presented and further developed. In contrast to the standard approaches, power prices with spikes as a non-Markovian stochastic process are modeled that allows for modeling spikes directly as self-reversing jumps. It is shown how this approach can be used to value and hedge European contingent claims on power with spikes. It is also shown that the values of European contingent claims on power with spikes satisfy the Cauchy problem for a certain linear evolution equation. In this way, the values of European contingent claims on power with spikes can be represented in terms of the Green's function for this Cauchy problem and the Green's function itself can be interpreted in terms of the values of the Arrow-Debreu securities on power with spikes.