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Hedging size risk: Theory and application to the US gas market

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  • Roncoroni, Andrea
  • Id Brik, Rachid

Abstract

Many corporate commitments exhibit a combined financial exposure to both market prices and idiosyncratic size components (e.g., volume, load, or business turnover). We design a customized contract to optimally mitigate the risk of joint fluctuations in price and size terms. The hedge is sought out among contingent claims written on price and any quoted index that is statistically dependent on commitment size. Closed-form solutions are derived for the optimal custom hedge pay-off and for the asset holdings of two market strategies, one based on price-linked forwards, the other based on price-linked and index-linked forwards. Analytical hedges are obtained using a stylized lognormal market model. Detailed comparative statics provide a thorough analysis of optimal hedging pay-off functions. Performance assessment is conducted in the context of the US gas market and a prototypical urban region. Results suggest that hedging through suitable custom claims written on price and an additional index significantly outperforms standard price-based as well as mixed price-index forward hedging alternatives. Our optimal custom hedge could be adopted as a benchmark for the relative assessment of any risk management solution.

Suggested Citation

  • Roncoroni, Andrea & Id Brik, Rachid, 2017. "Hedging size risk: Theory and application to the US gas market," Energy Economics, Elsevier, vol. 64(C), pages 415-437.
    • Handle: RePEc:eee:eneeco:v:64:y:2017:i:c:p:415-437
    DOI: 10.1016/j.eneco.2016.10.020
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    Cited by:

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    2. Jonathan Berrisch & Florian Ziel, 2022. "Distributional modeling and forecasting of natural gas prices," Journal of Forecasting, John Wiley & Sons, Ltd., vol. 41(6), pages 1065-1086, September.
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    4. Secomandi, Nicola, 2022. "Quadratic hedging of risk neutral values," Energy Economics, Elsevier, vol. 112(C).
    5. Haitao Xiang & Ying Kong & Wai Kin Victor Chan & Sum Wai Chiang, 2019. "Impact of Price–Quantity Uncertainties and Risk Aversion on Energy Retailer’s Pricing and Hedging Behaviors," Energies, MDPI, vol. 12(17), pages 1-20, August.

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    More about this item

    Keywords

    Corporate risk management; Commodity risk; Contract design;
    All these keywords.

    JEL classification:

    • C31 - Mathematical and Quantitative Methods - - Multiple or Simultaneous Equation Models; Multiple Variables - - - Cross-Sectional Models; Spatial Models; Treatment Effect Models; Quantile Regressions; Social Interaction Models
    • E43 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Interest Rates: Determination, Term Structure, and Effects
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions

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