Time Varying Risk Aversion: An Application to Energy Hedging
AbstractRisk 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 InfoPaper provided by arXiv.org in its series Papers with number 1103.5968.
Date of creation: Mar 2011
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Web page: http://arxiv.org/
Other versions of this item:
- Cotter, John & Hanly, Jim, 2010. "Time-varying risk aversion: An application to energy hedging," Energy Economics, Elsevier, vol. 32(2), pages 432-441, March.
- John Cotter & Jim Hanly, 2010. "Time Varying Risk Aversion: An Application to Energy Hedging," Working Papers 201007, Geary Institute, University College Dublin.
- G10 - Financial Economics - - General Financial Markets - - - General (includes Measurement and Data)
- G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
- G15 - Financial Economics - - General Financial Markets - - - International Financial Markets
This paper has been announced in the following NEP Reports:
- NEP-ALL-2011-04-09 (All new papers)
- NEP-ENE-2011-04-09 (Energy Economics)
- NEP-RMG-2011-04-09 (Risk Management)
- NEP-UPT-2011-04-09 (Utility Models & Prospect Theory)
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