Hedging strategies for energy derivatives

Abstract

In this article, we define a hedging strategy in a setting typical for the commodity market. Firstly, we prove the existence of the locally risk-minimizing (LRM) hedging strategy for payment streams in this setting. Next, a three-step procedure is described to determine the LRM hedging strategy. Then the procedure is illustrated for stochastic volatility models, as these models are a special case of the non-traded situation which frequently occurs in the commodity markets. Finally, we introduce the (adjusted) LRM hedging strategy in the non-traded setting and for this specific setting we numerically show the outperformance of this strategy compared with current market practices.

Keywords:

• Energy derivatives
• Hedging strategies
• Non-traded assets
• Local risk minimization
• Stochastic volatilty models

JEL Classification:

• G13
• G19

Acknowledgments

Nele Vandaele gratefully acknowledges the financial support by the Research Foundation-Flanders. The authors thank two anonymous referees and the editor for the valuable suggestions that improved the paper considerably.