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Minimal variance hedging of natural gas derivatives in exponential Lévy models: Theory and empirical performance

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  • Ewald, Christian-Oliver
  • Nawar, Roy
  • Siu, Tak Kuen

Abstract

We consider the problem of hedging European options written on natural gas futures, in a market where prices of traded assets exhibit jumps, by trading in the underlying asset. We provide a general expression for the hedging strategy which minimizes the variance of the terminal hedging error, in terms of stochastic integral representations of the payoffs of the options involved. This formula is then applied to compute hedge ratios for common options in various models with jumps, leading to easily computable expressions. As a benchmark we take the standard Black–Scholes and Merton delta hedges. We show that in natural gas option markets minimal variance hedging with underlying consistently outperform the benchmarks by quite a margin.

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  • Ewald, Christian-Oliver & Nawar, Roy & Siu, Tak Kuen, 2013. "Minimal variance hedging of natural gas derivatives in exponential Lévy models: Theory and empirical performance," Energy Economics, Elsevier, vol. 36(C), pages 97-107.
    • Handle: RePEc:eee:eneeco:v:36:y:2013:i:c:p:97-107
    DOI: 10.1016/j.eneco.2012.12.004
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    Cited by:

    1. Takuji Arai & Yuto Imai & Ryoichi Suzuki, 2016. "Numerical Analysis On Local Risk-Minimization For Exponential Lévy Models," International Journal of Theoretical and Applied Finance (IJTAF), World Scientific Publishing Co. Pte. Ltd., vol. 19(02), pages 1-27, March.
    2. Donald Lien & Ziling Wang & Xiaojian Yu, 2021. "Optimal quantile hedging under Markov regime switching," Empirical Economics, Springer, vol. 60(5), pages 2177-2201, May.
    3. Takuji Arai & Yuto Imai & Ryoichi Suzuki, 2015. "Numerical analysis on local risk-minimization forexponential L\'evy models," Papers 1506.03898, arXiv.org.

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    More about this item

    Keywords

    Quadratic hedging; Jump-diffusion models; Natural gas options; Energy derivatives; Resource economics;
    All these keywords.

    JEL classification:

    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • Q49 - Agricultural and Natural Resource Economics; Environmental and Ecological Economics - - Energy - - - Other

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