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A Utility Based Approach to Energy Hedging

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  • John Cotter
  • Jim Hanly

Abstract

A key issue in the estimation of energy hedges is the hedgers' attitude towards risk which is encapsulated in the form of the hedgers' utility function. However, the literature typically uses only one form of utility function such as the quadratic when estimating hedges. This paper addresses this issue by estimating and applying energy market based risk aversion to commonly applied utility functions including log, exponential and quadratic, and we incorporate these in our hedging frameworks. We find significant differences in the optimal hedge strategies based on the utility function chosen.

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Paper provided by arXiv.org in its series Papers with number 1103.5973.

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Date of creation: Mar 2011
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Handle: RePEc:arx:papers:1103.5973

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  1. John Cotter & Jim Hanly, 2011. "Time Varying Risk Aversion: An Application to Energy Hedging," Papers 1103.5968, arXiv.org.
  2. Harry Markowitz, 1952. "Portfolio Selection," Journal of Finance, American Finance Association, vol. 7(1), pages 77-91, 03.
  3. Ederington, Louis H, 1979. "The Hedging Performance of the New Futures Markets," Journal of Finance, American Finance Association, vol. 34(1), pages 157-70, March.
  4. Eric Ghysels & Pedro Santa-Clara & Rossen Valkanov, 2004. "There is a Risk-Return Tradeoff After All," CIRANO Working Papers 2004s-24, CIRANO.
  5. Stephen G. Cecchetti & Robert E. Cumby & Stephen Figlewski, 1986. "Estimation of the optimal futures hedge," Research Working Paper 86-10, Federal Reserve Bank of Kansas City.
  6. Alberto Giovannini & Philippe Jorion, 1988. "The Time-Variation of Risk and Return in the Foreign Exchange and Stock Markets," NBER Working Papers 2573, National Bureau of Economic Research, Inc.
  7. Kroner, Kenneth F. & Sultan, Jahangir, 1993. "Time-Varying Distributions and Dynamic Hedging with Foreign Currency Futures," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 28(04), pages 535-551, December.
  8. David Cabedo, J. & Moya, Ismael, 2003. "Estimating oil price 'Value at Risk' using the historical simulation approach," Energy Economics, Elsevier, vol. 25(3), pages 239-253, May.
  9. Brandt, Michael W. & Wang, Kevin Q., 2003. "Time-varying risk aversion and unexpected inflation," Journal of Monetary Economics, Elsevier, vol. 50(7), pages 1457-1498, October.
  10. Bollerslev, Tim & Engle, Robert F & Wooldridge, Jeffrey M, 1988. "A Capital Asset Pricing Model with Time-Varying Covariances," Journal of Political Economy, University of Chicago Press, vol. 96(1), pages 116-31, February.
  11. Townsend, R.M., 1991. "Risk and Insurance in Village India," University of Chicago - Economics Research Center 91-3, Chicago - Economics Research Center.
  12. Regnier, Eva, 2007. "Oil and energy price volatility," Energy Economics, Elsevier, vol. 29(3), pages 405-427, May.
  13. Engle, Robert F & Lilien, David M & Robins, Russell P, 1987. "Estimating Time Varying Risk Premia in the Term Structure: The Arch-M Model," Econometrica, Econometric Society, vol. 55(2), pages 391-407, March.
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Cited by:
  1. Thomas Conlon & John Cotter, 2012. "Downside risk and the energy hedger's horizon," Working Papers 201219, Geary Institute, University College Dublin.
  2. John Cotter & Jim Hanly, 2014. "Performance of Utility Based Hedges," Working Papers 201404, Geary Institute, University College Dublin.
  3. Dinica, Mihai Cristian & Armeanu, Daniel, 2014. "The Optimal Hedging Ratio for Non-Ferrous Metals," Journal for Economic Forecasting, Institute for Economic Forecasting, vol. 0(1), pages 105-122, March.

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