Hedging Strategy and Electricity Contract Engineering - IFOR

Chapter 3
Risk management
3.1. Overview
Risk Management is the theory about how to handle risks. The need for
risk management comes with potentially risky and complex products, such
as derivatives. The first standardized options were traded in 1973 when the
Chicago Board Options Exchange began its operations. The same year the
paper on valuation of options by Black and Scholes [BS73] was published,
which helped to increase the number of derivative deals.
There are to date no operational valuation model of electricity derivatives
based on a sound academic ground, such as the Black & Scholes model [BS73]
for equity derivatives. Nevertheless, the deregulation and the, with it coming,
uncertain prices has developed a need for risk transferring products like options
and futures. The difference is that while the traditional finance industry had
tens of years to develop their methods to handle risk, the electricity industry
is facing at least the same risks, but has had only a few years to learn how to
manage them.
In Chapter 3.2 a motivation and introduction to risk management is given. The
risks in the electricity market are introduced in Chapter 3.3. Some traditional
risk management models are investigated in Chapter 3.4. Their shortcomings
and the need for a new risk measure are discussed in Chapter 3.5. Multi period