A New Approach to Evaluating the Cost-Efficiency of Complex Hedging Strategies: An Application to Electricity Price–Volume Quanto Contracts

27 Pages Posted: 24 Sep 2019

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

Saint Mary's University of San Antonio

Date Written: September 19, 2019

Abstract

Electricity quanto contracts improve the efficiency of financial risk management by accommodating the correlated price and volumetric risks of energy suppliers. The use of electricity quanto contracts, however, suffers from the high risk premiums associated with such tailor-made and illiquid financial instruments. As a result, it is of great interest to properly evaluate the cost-efficiency of these complex hedging deals. To address this concern, we propose a new hedging assessment model, the economic value of the incremental expected shortfall (EVIES), from a cost-efficiency perspective. Using EVIES, we develop a Monte Carlo simulation-based hedging framework. This framework overcomes the limits of traditional models by not resting on risk neutrality, market completeness or unobservable inputs. In our numerical examples, we assume that a fictitious power supplier has access to electricity price derivatives, weather derivatives and electricity quanto contracts, and we show that our proposed model can be applied to:

(1) construct a cost-effective hedge against an electricity price–volume joint risk,

(2) find a partial equilibrium for the valuation of electricity quanto contracts and

(3) locate hedging solutions for achieving a specific risk management target.

Keywords: electricity market, hedging evaluation, quanto contracts, financial risk management, cost-efficiency

Suggested Citation

Kang, Sang Baum and Ong, Michael and Zhao, Jialin, A New Approach to Evaluating the Cost-Efficiency of Complex Hedging Strategies: An Application to Electricity Price–Volume Quanto Contracts (September 19, 2019). Journal of Energy Markets, Vol. 12, No. 3, 2019, Available at SSRN: https://ssrn.com/abstract=3456706

Sang Baum Kang

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

565 W Adams St
Room 454
Chicago, IL
United States
312-906-6577 (Phone)

Michael Ong

Michael K. Ong Risk Advisory ( email )

Chicago, IL
United States

Jialin Zhao (Contact Author)

Saint Mary's University of San Antonio ( email )

One Camino Santa Maria
San Antonio, TX 78228
United States

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