Hedging Strategy and Electricity Contract Engineering - IFOR

104 Hedging strategies
been published motivating corporate hedging in imperfect markets, like the
Smith & Stulz [SS85] paper about convex taxation and the paper by Brealey
& Myers [BM00] about bankruptcy and financial distress costs. Ross [Ros96]
addresses that hedging permits greater leverage and thus a more efficient tax
shield. Since the electricity market is indeed imperfect, caused by, for example,
transaction costs to mention one imperfection, we can conclude that the
literature supports corporate hedging in the electricity market
In Chapter 5.2 we give an introduction to some traditional hedging strategies.
These approaches are then in Chapter 5.3 evaluated for the electricity market
and because of their shortcomings we introduce our approach best hedge in
Chapter 5.4.
5.2. Traditional hedging
Replicating hedge The most simple way to hedge a position is to enter an
identical, but opposite position to off-set all the risk. The currency risk, for
example, of a known future positive cash flow in an foreign currency can be
off-set by selling the same amount of that currency on a future basis. One tries
to replicate the risky position that is to be hedged and takes a short position
in that replication. For linear positions, whose price is linear in the underlying
price, futures are generally the simplest hedging instrument. 2 If the goal is to
minimize the risk with a future that does not behave equivalent to the position
that is to be hedged, it might not be optimal from a hedging point of view to
enter a future with the same underlying amount as the position to be hedged.
Under certain assumptions one can actually find the optimal future position that
minimizes the risk.
Optimal hedge ratio Assume that a company holds a long spot position
that it wants to hedge with a future. Å Let S define the change in spot price S,
during the period of time equal to the life of the Å hedge. F defines the change
in futures price F, during the same period. The standard deviation Å of S and
F are given by Æ S and Æ F respectively. The correlation between Å S and Å F
Å
is given Ç by and the hedge ratio, defined as the position in the future divided
2 Basically all instruments except derivatives with assymetric payoffs, like options are
linear.