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Time Varying Risk Aversion: An Application to Energy Hedging

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  • John Cotter

    (School of Business, University College Dublin)

  • Jim Hanly

    (School of Accounting and Finance, Dublin Institute of Technology)

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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File URL: http://www.ucd.ie/geary/static/publications/workingpapers/gearywp201007.pdf
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Bibliographic Info

Paper provided by Geary Institute, University College Dublin in its series Working Papers with number 201007.

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Length: 45 pages
Date of creation: 01 Jan 2010
Date of revision:
Handle: RePEc:ucd:wpaper:201007

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Keywords: Energy; Hedging; Risk Management; Risk Aversion; Forecasting;

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  1. 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.
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Cited by:
  1. John Cotter & Jim Hanly, 2011. "A Utility Based Approach to Energy Hedging," Papers 1103.5973, arXiv.org.
  2. Thomas Conlon & John Cotter, 2012. "Downside risk and the energy hedger's horizon," Working Papers 201219, Geary Institute, University College Dublin.

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