Giant Trading Losses – What not to do? Chapter 2: Nordic German Electricity Futures Arbitrage (Einar Aas)

Background: Nordic & German power grids are well connected. Distribution utilities will seek average the cost of power, thereby eliminating the price difference between the 2 power sources. The trade: Bet that spread (difference between German and Nordic prices) will converge. The trade: long position on Nordic power (cheaper contract) short position on German power (more expensive contract) The price difference is likely to be small, so to be able to make profit, we need to lever up. We estimate he was levered up 30 – 40 times. The hidden flaw in the trade: Poor understanding of mean reversion phenomenon…....