Extreme value theory - its application to energy markets

Abstract

The energy market is a very important sector of the economy. Oil is the primary source of energy for transportation and power, with natural gas being used in industry, electricity production and in households. Since this is a very important raw material in the economy it is therefore an important task to manage the risk of adverse fluctuations in the prices of these fuels. One of the frequently used tools for safeguarding the risk management process against adverse changes is value at risk (VaR). Due the volatility of energy markets, implementing an effective risk management system becomes an urgent necessity. The VaR methodology as a measure of market risk has gained rapid acceptance and popularity by both institutions and regulators. Moreover, Extreme Value Theory has been successfully applied in many fields where extreme values may appear. In this paper Extreme Value Theory models are compared to conventional models such as Historical Simulation. Our results indicate that Extreme Value Theory offers a better estimation of Value at Risk than traditional methods.