Pricing and Hedging Illiquid Energy Derivatives: An Application to the JCC Index

28 Pages Posted: 25 Oct 2006

See all articles by Matteo Manera

Matteo Manera

University of Milan-Bicocca, Italy - Department of Economics, Management and Statistics (DEMS); Fondazione Eni Enrico Mattei (FEEM), Milan, Italy

Elisa Scarpa

Edison Trading

Date Written: October 2006

Abstract

In this paper we discuss a simple strategy for pricing and hedging illiquid financial products, such as the Japanese crude oil cocktail (JCC) index, the most popular OTC energy derivative in Japan. First, we review the existing literature for computing optimal hedge ratios (OHR) and we propose a critical classification of the existing approaches. Second, we compare the empirical performance of different econometric models (namely, regression models for price levels, price first differences, and price returns, as well as error correction and autoregressive distributed lag models) in terms of their computed OHR, using monthly data on the JCC over the period Janury 2000-January 2006. Third, we illustrate and implement a reliable procedure to price and hedge a swap contract on the JCC with a variable oil volume. We explain how to compute a bid/ask spread and to construct the hedging position for the JCC swap. Fourth, we evaluate our swap pricing scheme with backtesting and rolling regression techniques. Our empirical findings show that it is not necessary to use complicated econometric techniques, since the price-level regression model permits to compute more precise optimal hedge ratios relative to its competing alternatives.

Keywords: Hedging models, Cross-hedging, Energy derivatives, Illiquid financial products, Commodity markets, JCC price index

JEL Classification: G13, G15

Suggested Citation

Manera, Matteo and Scarpa, Elisa, Pricing and Hedging Illiquid Energy Derivatives: An Application to the JCC Index (October 2006). FEEM Working Paper No. 130.2006, Available at SSRN: https://ssrn.com/abstract=938932 or http://dx.doi.org/10.2139/ssrn.938932

Matteo Manera (Contact Author)

University of Milan-Bicocca, Italy - Department of Economics, Management and Statistics (DEMS) ( email )

Via Bicocca degli Arcimboldi, 8
Milan, 20126
Italy
+39 02 6448 5819 (Phone)
+39 02 6448 5878 (Fax)

HOME PAGE: http://www.matteomanera.it

Fondazione Eni Enrico Mattei (FEEM), Milan, Italy ( email )

Corso Magenta, 63
Milan, 20123
Italy
+39 02 520 36944 (Phone)

HOME PAGE: http://www.feem.it

Elisa Scarpa

Edison Trading ( email )

Foro Buonaparte, 31
Milan, 20121
Italy

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