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Time Varying Risk Aversion: An Application to Energy Hedging

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  • John Cotter
  • Jim Hanly

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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Paper provided by arXiv.org in its series Papers with number 1103.5968.

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Date of creation: Mar 2011
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Handle: RePEc:arx:papers:1103.5968

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Cited by:
  1. John Cotter & Jim Hanly, 2011. "A Utility Based Approach to Energy Hedging," Working Papers, Geary Institute, University College Dublin 201106, Geary Institute, University College Dublin.
  2. Conlon, Thomas & Cotter, John, 2013. "Downside risk and the energy hedger's horizon," Energy Economics, Elsevier, Elsevier, vol. 36(C), pages 371-379.

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