The Incremental Expected Shortfall-Based Pricing: Application to a Cost-Effective Hedge of an Electricity Price-Volume Quanto Risk

35 Pages Posted: 14 Mar 2016

See all articles by Sang Baum Kang

Sang Baum Kang

Illinois Institute of Technology - Stuart School of Business

Michael Ong

Michael K. Ong Risk Advisory

Jialin Zhao

Illinois Institute of Technology - Stuart School of Business, IIT

Date Written: February 26, 2016

Abstract

To evaluate complex hedging deals from a cost-efficiency perspective, this paper proposes a new hedging-effectiveness measure, the Economic Value of the Incremental Expected Shortfall (EV-IES), which summarizes the costs and benefits of a hedging strategy by taking into account firm-specific and observable variables such as the weighted average cost of capital and the marginal corporate tax rate. The EV-IES, shown to be monotonic, concave, and scale-invariant, offers an intuitive and clear guideline regarding acceptance/rejection of a proposed hedging deal. To illustrate the application of the EV-IES, our empirical study considers a fictitious Chicago-based electricity load-serving entity facing a price-volume joint risk. Using electricity price derivatives, weather derivatives, and tailor-made electricity-temperature quantity-adjusting (quanto) contracts, we illustrate how to find an optimally cost-efficient hedging strategy, a break-even premium for quanto contracts, and a hedging strategy for achieving a firm's target expected shortfall level.

Keywords: Hedging Evaluation, Quanto Contracts, Financial Risk Management

Suggested Citation

Kang, Sang Baum and Ong, Michael and Zhao, Jialin, The Incremental Expected Shortfall-Based Pricing: Application to a Cost-Effective Hedge of an Electricity Price-Volume Quanto Risk (February 26, 2016). Available at SSRN: https://ssrn.com/abstract=2747146 or http://dx.doi.org/10.2139/ssrn.2747146

Sang Baum Kang

Illinois Institute of Technology - Stuart School of Business ( email )

565 W Adams St
Room 454
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312-906-6577 (Phone)

Michael Ong

Michael K. Ong Risk Advisory ( email )

Chicago, IL
United States

Jialin Zhao (Contact Author)

Illinois Institute of Technology - Stuart School of Business, IIT ( email )

10 West 35th Street, 18th Floor
Chicago, IL 60616
United States

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