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Time-varying risk aversion: An application to energy hedging

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  • Cotter, John
  • Hanly, Jim

Abstract

Risk aversion is a key element of utility maximizing hedge strategies; however, it has typically been assigned an arbitrary value in the literature. This paper instead applies a GARCH-in-Mean (GARCH-M) model to estimate a time-varying measure of risk aversion that is based on the observed risk preferences of energy hedging market participants. The resulting estimates are applied to derive explicit risk aversion based optimal hedge strategies for both short and long hedgers. Out-of-sample results are also presented based on a unique approach that allows us to forecast risk aversion, thereby estimating hedge strategies that address the potential future needs of energy hedgers. We find that the risk aversion based hedges differ significantly from simpler OLS hedges. When implemented in-sample, risk aversion hedges for short hedgers outperform the OLS hedge ratio in a utility based comparison.

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Bibliographic Info

Article provided by Elsevier in its journal Energy Economics.

Volume (Year): 32 (2010)
Issue (Month): 2 (March)
Pages: 432-441

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Handle: RePEc:eee:eneeco:v:32:y:2010:i:2:p:432-441

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Web page: http://www.elsevier.com/locate/eneco

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Keywords: Energy Hedging Risk management Risk aversion Forecasting;

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References

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  17. Frankel, Jeffrey A., 1982. "In search of the exchange risk premium: A six-currency test assuming mean-variance optimization," Journal of International Money and Finance, Elsevier, vol. 1(1), pages 255-274, January.
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Cited by:
  1. Conlon, Thomas & Cotter, John, 2013. "Downside risk and the energy hedger's horizon," Energy Economics, Elsevier, vol. 36(C), pages 371-379.
  2. John Cotter & Jim Hanly, 2011. "A Utility Based Approach to Energy Hedging," Papers 1103.5973, arXiv.org.

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