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A Utility Based Approach to Energy Hedging

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  • John Cotter

    (University College Dublin)

  • Jim Hanly

    (Dublin Institute of Technology)

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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File URL: http://www.ucd.ie/geary/static/publications/workingpapers/gearywp201106.pdf
File Function: First version, 2011
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Bibliographic Info

Paper provided by Geary Institute, University College Dublin in its series Working Papers with number 201106.

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Length: 47 pages
Date of creation: 02 Mar 2011
Date of revision:
Handle: RePEc:ucd:wpaper:201106

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

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References

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  1. Eric Ghysels & Pedro Santa-Clara & Rossen Valkanov, 2003. "There is a Risk-Return Tradeoff After All," CIRANO Working Papers 2003s-26, CIRANO.
  2. 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.
  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. 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.
  5. Robert M. Townsend, . "Risk and Insurance in Village India," University of Chicago - Population Research Center 91-3a, Chicago - Population Research Center.
  6. Regnier, Eva, 2007. "Oil and energy price volatility," Energy Economics, Elsevier, vol. 29(3), pages 405-427, May.
  7. 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.
  8. Cecchetti, Stephen G & Cumby, Robert E & Figlewski, Stephen, 1988. "Estimation of the Optimal Futures Hedge," The Review of Economics and Statistics, MIT Press, vol. 70(4), pages 623-30, November.
  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. Cotter, John & Hanly, Jim, 2010. "Time-varying risk aversion: An application to energy hedging," Energy Economics, Elsevier, vol. 32(2), pages 432-441, March.
  11. 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.
  12. Harry Markowitz, 1952. "Portfolio Selection," Journal of Finance, American Finance Association, vol. 7(1), pages 77-91, 03.
  13. 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.
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Cited by:
  1. 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.
  2. Thomas Conlon & John Cotter, 2012. "Downside risk and the energy hedger's horizon," Working Papers 201219, Geary Institute, University College Dublin.
  3. John Cotter & Jim Hanly, 2014. "Performance of Utility Based Hedges," Working Papers 201404, Geary Institute, University College Dublin.

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