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Liquidity and dirty hedging in the Nordic electricity market

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  • Frestad, Dennis

Abstract

Hedging involves tradeoffs in incomplete markets because the number of hedging instruments is limited. Even when an extensive set of hedging instruments is available, the ease with which these instruments can be traded may be highly variable. This study finds systematic variations in liquidity in different segments of the Nordic electricity swap market and analyzes the potential for replacing low-liquidity, delivery-period-matched hedging instruments with more liquid, delivery-period-mismatched hedging instruments. When the costs of implementing such dirty hedging strategies are lower than those of the replaced hedging instruments and the loss of hedge effectiveness is small, dirty hedging strategies may then replace their delivery-period-matched counterparts. In this context, I analyze the dynamic out-of-sample tracking performance of selected dirty hedges. Electricity swaps with delivery in front year one and two, respectively, track electricity swaps with delivery in front year three quite well. This suggests that hedge effectiveness can be traded off for the reduced costs of implementing these dirty hedging strategies compared with those of the less liquid year-three swaps.

Suggested Citation

  • Frestad, Dennis, 2012. "Liquidity and dirty hedging in the Nordic electricity market," Energy Economics, Elsevier, vol. 34(5), pages 1341-1355.
    • Handle: RePEc:eee:eneeco:v:34:y:2012:i:5:p:1341-1355
    DOI: 10.1016/j.eneco.2012.06.017
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    Cited by:

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    2. IKEDA Shin Suke, 2017. "Illiquidity in the Japan Electric Power Exchange," Discussion papers 17122, Research Institute of Economy, Trade and Industry (RIETI).
    3. Shrestha, Keshab & Subramaniam, Ravichandran & Peranginangin, Yessy & Philip, Sheena Sara Suresh, 2018. "Quantile hedge ratio for energy markets," Energy Economics, Elsevier, vol. 71(C), pages 253-272.
    4. Simon Hagemann & Christoph Weber, 2013. "An Empirical Analysis of Liquidity and its Determinants in The German Intraday Market for Electricity," EWL Working Papers 1317, University of Duisburg-Essen, Chair for Management Science and Energy Economics, revised Oct 2013.
    5. Zhang, Yue & Farnoosh, Arash, 2019. "Analyzing the dynamic impact of electricity futures on revenue and risk of renewable energy in China," Energy Policy, Elsevier, vol. 132(C), pages 678-690.
    6. Egil Ferkingstad & Anders L{o}land, 2014. "Coping with area price risk in electricity markets: Forecasting Contracts for Difference in the Nordic power market," Papers 1406.6862, arXiv.org.
    7. Shrestha, Keshab & Subramaniam, Ravichandran & Rassiah, Puspavathy, 2017. "Pure martingale and joint normality tests for energy futures contracts," Energy Economics, Elsevier, vol. 63(C), pages 174-184.
    8. Nicola Secomandi & Guoming Lai & François Margot & Alan Scheller-Wolf & Duane J. Seppi, 2015. "Merchant Commodity Storage and Term-Structure Model Error," Manufacturing & Service Operations Management, INFORMS, vol. 17(3), pages 302-320, July.
    9. Bevin-McCrimmon, Fergus & Diaz-Rainey, Ivan & McCarten, Matthew & Sise, Greg, 2018. "Liquidity and risk premia in electricity futures," Energy Economics, Elsevier, vol. 75(C), pages 503-517.
    10. Ikeda, Shin S., 2019. "Illiquidity in the Japan electric power exchange," Journal of Commodity Markets, Elsevier, vol. 14(C), pages 16-39.

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