Pricing options on EU ETS certificates with a time-varying market price of risk model

Abstract

To price options on emission certificates reduced-form models have proved to be useful.We empirically analyse the performance of the model proposed in Carmona and Hinz [2] and Hinz [8]. As we find evidence for a time-varying market price of risk, we extend the Carmona-Hinz framework by introducing a bivariate pricing model. We show that the extended model is able to extract information on the market price of risk and evaluate its impact on the EUA options.