Modeling CO[subscript 2] emission allowance derivatives

Abstract

Efficient pricing of carbon derivative product is the core of the EU-ETS system, which plays an important role in keeping stability and developing the carbon financial market. The volatility of the underlying assets is the essential factor, so how to get the features of the volatility effectively becomes a key problem. Although the B-S model gives a classic tool for option pricing, it is based on the assumption that the volatility is constant. Increasingly, the research finds that financial data exhibit fat-tail and high kurtosis, so the assumption of constant volatility is not suitable. In this paper we first analyse the carbon emissions trading market, and then we use a GARCH model to appropriately reproduce the dynamics of the EUA futures` returns. We obtain the conclusions that GARCH (1,1) model is appropriately to reproduce the futures dynamics.