Abstract
We consider a slight perturbation of the Schwartz-Smith model for the electricity futures prices and the resulting modified spot model. Using the martingale property of the modified price under the risk neutral measure, we derive an arbitrage free model for the spot and futures prices. As the futures price formula is based on the arithmetic average of the spot prices, it is highly non-linear. Hence, we use the particle filtering methodology as our identification method for estimation. The main advantage of the new model is that it avoids the inclusion of artificial noise to the observation equation for the implementation of the particle filter. The extra noise is build within the model in an arbitrage free setting.
