Assessing the influence of spot price predictability on electricity futures hedging

Abstract

A common feature of energy prices is that spot price changes are partially predictable due to weather and demand seasonalities. This paper follows the Ederington and Salas (2008) framework and considers the expected change in spot prices when minimum variance hedge ratios are computed. The poor effectiveness of hedging strategies obtained in previous studies on electricity was because the standard hedging approach underestimates the effectiveness of hedging. In the empirical study made in this paper, weekly spot price risk is hedged with weekly futures in the Nord Pool electricity market. In this case, the optimal selection of the futures contract may produce risk reductions whose values vary between 60% and 80% -depending on the hedging duration (one to three weeks) and the analysed sub-period (in-sample and out-of-sample sub-periods).

Hedging spark spread risk with futures

“…For example, a risk reduction for monthly periods produced by optimal strategies is underestimated by between 7.56 and 27.37 per cent in the spark spreads. For the constituents of the spark spread these values are somewhat higher and more consistent across markets and strategies as it was expected from previous results in the area (see Torró, 2011, andEderington andSalas, 2008).…”

“…The reason for the existence of these forecastable pattern in the spark spread comes from the existence of seasonal patterns in energy commodity demand due to climate oscillation throughout the year. Previous results in Torró (2011) and Martinez and Torró (2015) confirm the existence of this feature in European electricity and natural gas markets, but this is the first time it is found in spark spreads. Table 7.…”

“…This is the first-time that spark spread risk hedge is discussed in the doctrine using financial futures. There are several papers on electricity and natural gas price risk management, but no paper has attempted to simultaneously determine the optimal position in futures on electricity and natural gas to hedge spark spread risk (see for example Torró, 2011, andMartinez andTorró, 2016). We show that clean spark spread risk and spark spread risk are two indistinguishable variables for futures hedging purposes.…”

“…At the Nord Pool, Bystrom (2003) obtains risk reductions that range between 7% and 29% for weekly hedges. In Torró (2011), weekly spot price risk is hedged with weekly futures in the Nord Pool electricity market. It is shown that increasing the hedging period and closing futures positions near to its maturity may produce risk reductions over to 80%.…”

Hedging Performance and Multiscale Relationships in the German Electricity Spot and Futures Markets

“…Electricity markets are of considerable interest and challenging in terms of modeling and hedging due to non-storability, strong seasonal fluctuations, price spikes and their highly volatile price behavior (Huisman, Huurman and Mahieu, 2007) 1 . Hedgers in these markets use futures to reduce the risk from variations in the spot market (Torró, 2009;Zanotti, Gabbi and Geranio, 2010). Since futures are a derivative security from the spot market, it should be safe to say that both are subject to the same impacts from market fundamentals, and that both series should be highly co-integrated.…”