Hedging Strategy and Electricity Contract Engineering - IFOR

112 Hedging strategies
Contract to be hedged
(Load factor contract)
Contracts
- Spot
- Futures
- Options Best hÕ edge
Production
- Gas turbine
- Hydro storage plant
Ô
ng LoÖ
10 MW futures
1 MW options
1 MW gas turbine
×
rt ShoÖ
Load factor
contract (~11MW)
Spot market as buffer
Ø
Fig. 5.2: Illustration of best hedge procedure.
options and we need an internal price to be assigned to both, otherwise we
would optimally choose to allocate the whole capacity of the gas turbine and
the hydro plant in our best hedge. 5 This would naturally put the next contract
to be hedged in a bad situation, having to rely only on traded contracts. With
our notation the contract to be hedged x h is the load factor contract with its
stochastic demand, whereas the contracts used in the best hedge x x h are
given by spots, futures, options, the gas turbine and the hydro storage plant.
Figure 5.2 illustrates such a procedure, where the best hedge is achieved
through going long 10 MW in the futures market, buying call options on
1 MW, allocating 1 MW of the gas turbine and using the spot market as a
buffer for the stochastic demand. In this case the hydro storage plant was too
expensive. The illustration is only schematic and is not a result from a real
optimization. In Chapter 7 we will however perform a similar optimization of
a real power portfolio.
The players in a financial market are normally categorized as hedgers, speculators
and arbitrageurs [Hul97]. Hedgers are interested in reducing the risk
5 Observe that if the plants are not assigned an internal price we could buy ’options’ at
zero cost.