Hedging Strategy and Electricity Contract Engineering - IFOR

5.3 Relevance for electricity hedging 109
hedged position will be locally immune to parallel shifts in the yield curve. A
mayor drawback of the duration approach is however just the assumption that
the yieldcurve will move in parallel shifts - not a very realistic assumption.
5.3. Relevance for electricity hedging
An important question is how one could leverage these traditional hedging
approaches to the electricity market. The idea of closing down a positions
and hence its risk by entering a replicating position is certainly a sound
approach also in the electricity market. However, because of the complexity
and the OTC characteristics of most electricity contracts, the replicating hedge
approach would only be able to cover a small subset of all contracts.
As already argued in Chapter 3.5, variance is not an appropriate risk measure
in the electricity market, for example, because of the heavy tailed returns, why
an optimal hedge ratio as described above would need to revised to fit the
electricity market.
Since the electricity market is incomplete, it may be difficult to obtain unique
prices of electricity derivatives 4 and consequently sensitivities may not be
obtained. The idea of delta and delta/gamma hedging will therefore be difficult
to pursue.
Even given that unique prices would exist for electricity derivatives, the nonstorability
prevents us from taking the delta or delta/gamma hedge approach.
The idea is to hold a certain amount (Å ) of the underlying in order to make the
portfolio of the derivative and the underlying locally immune, but one cannot,
because of its non-storability hold on to electricity. For options on a storable
underlying, such as a future, the approach would however be theoretically
feasible.
A duration-like method is appropriate also in the electricity market only in the
sense that a long position should be hedged with a short position of the same
4 See Chapter 3.7.