How do I use Delivered Volatility?

Let's illustrate the answer with a detailed example using Excel.

Delivered Volatility: Delivered volatility tells us how much the average of the delivery month's spot prices can vary from the current forward price, assuming the today's forward price is unchanged at the beginning of delivery. The primary driver of delivered volatility is weather while spot month fuel price volatility is a secondary factor.

Delivered volatility differs from forward volatility and implied volatility. There are no analogs elsewhere in finance. It measures a key distinction where power markets differ from every other market while capturing and sequestering power market assumption violations. Delivered volatility is reported as a non-annualized percentage. Why? Conventional models of volatility presume that uncertainty dissipates over time. This is not true for power.

Context: Please refer to the pdf sample or the sample clip on the website for the context details. Today is September 18, 2008 and we are in CT Zone in ISO-NE (Connecticut). The forward Power Nominals valuation for January 2009 is $112.42 and the delivered volatility for January is 14.8%. Delivered volatility is computationally simpler than forward volatility because we do not need to de-annualize first.

Problem: What is the likelihood that the CT Zone spot average will be above $130? Below $100.00?

PriceAsof = Today’s price

= $112.42

Delivered volatility

Dvol = 0.1480 = 14.8%

PriceUp

= $130.00

PriceRelative

PR = LN(PriceUp/PriceAsof)

= LN(130/112.42)

= 0.145 = Up 14.5%

Probability Price >$130.00?

= 1 - Normdist(PR,0,DVol, TRUE)

= 1 - Normdist(0.145,0,0.1480,TRUE)

= 0.163 = 16.3%

Conclusion: The probability that CT Zone spot prices for January will be above $130.00 is 16.3%, given that the current forward estimate of $112.42 is the same at the end of December.

Probability Price < $100.00?

PR = LN(PriceDn/PriceAsof)

= LN(100/112.42)

=  -0.117 = Down 11.7%

= NORMDIST(-0.117,0,0.1480,TRUE)

= 0.214 = 21.4%

Conclusion: The probability that CT Zone spot prices for January will average below $100.00 is 21.4%, given that the current forward estimate of $112.42 is the same at the end of December.