Hedging Strategy and Electricity Contract Engineering - IFOR

110 Hedging strategies
maturity, and vice versa. A duration-like weighted life time of an electricity
contract could probably be introduced, but since the duration method already
in the fixed income market has mayor drawbacks, it would not be a suitable
candidate for an electricity hedging approach.
The complicated price process of electricity, the complex contracts involving
not only price risk, but also volume risk and the additional dimension of the
production side calls for a more sophisticated and general hedging approach
than the presented traditional approaches. We will in the next section introduce
a hedging approach that we believe is suited for the electricity market, which
we call best hedge.
5.4. Best Hedge
The non-storability of electricity and hence the impossibility to pursue
cash-and-carry strategies in combination with the fact that futures and other
standardized derivatives only are available at a limited number of nodes in
the grid makes it difficult to find perfect hedges for electricity positions. With
perfect hedge we mean a hedge that totally eliminates the price risk in a
position. We know from Definition 3.7 that the electricity market is incomplete
and hence that only a subset of all contingent claims are replicatable. It is
therefore in the electricity market in general not possible to find such a perfect
hedge .
Our approach is instead to find the best possible hedge. If we return to Definition
5.1, where hedge is defined as an action that reduces risk, usually at
the expense of potential reward, it seems natural to state that the best hedge is
a hedge that minimizes the risk, under some constraint on the expense of potential
reward. This sounds similar to the optimal hedge ratio approach, but as
mentioned, variance is not a good measure of risk in the electricity market, and
the optimal hedge ratio does not consider the costs associated with the hedge.
In Chapter 3.5 we argued that CVaR is an appropriate risk measure in this market,
hence CVaR will instead of variance be used as measure of risk. A hedging
approach is needed that can handle all types of complex electricity contracts.
We believe that the best hedge is one such approach, which is obtained by finding
the hedge that minimizes the risk, in terms of CVaR under the constraint