Time Varying Risk Aversion: An Application to Energy Hedging

45 Pages Posted: 4 Dec 2009

See all articles by John Cotter

John Cotter

University College Dublin; UCLA Anderson School of Management

Jim Hanly

Technological University Dublin

Date Written: December 2, 2009

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.

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

JEL Classification: G1, G12, G15

Suggested Citation

Cotter, John and Hanly, Jim, Time Varying Risk Aversion: An Application to Energy Hedging (December 2, 2009). Available at SSRN: https://ssrn.com/abstract=1517112 or http://dx.doi.org/10.2139/ssrn.1517112

John Cotter (Contact Author)

University College Dublin ( email )

School of Business, Carysfort Avenue
Blackrock, Co. Dublin
Ireland
353 1 716 8900 (Phone)
353 1 283 5482 (Fax)

HOME PAGE: http://www.ucd.ie/bankingfinance/staff/professorjohncotter/

UCLA Anderson School of Management ( email )

110 Westwood Plaza
Los Angeles, CA 90095-1481
United States

Jim Hanly

Technological University Dublin ( email )

Dublin
Ireland
+35314023180 (Phone)

HOME PAGE: http://www.jimhanly.com

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