Abstract
We explore optimal hedge ratios and hedging effectiveness for the German electricity market. Given the increasing attention that wavelets received in the financial market, we concentrate on the investigation of the relationship, covariance/coherence evolution and hedge ratio analysis, on a time-frequency-scale approach (discrete and continuous), between electricity spot and futures. Simpler approaches are also used for comparison purposes like the naïve, OLS and the dynamic multivariate GARCH model in order to account for risk reduction through hedging. Results allow us to conclude that: dynamic hedging strategies provide higher variance reductions in terms of hedging effectiveness; there is poor correlation among spot and futures, not being homogeneous across scales, which condition the effectiveness of the hedging strategy; the long-horizon hedge ratio does not converge to its long run equilibrium of one. Wavelets poor fit in variance reduction is attributed to low coherence and to statistical relationships between spot and futures electricity series. The instability found in various aspects of market comovements may imply serious limitations to the investor’s ability to exploit potential benefits from hedging with futures contracts in electricity markets. Moreover, much variation in the contemporaneous relationship among spot and futures may highlight inadequacy in assuming (short-term) relationships in both markets, which might account for the difficulty in achieving profitable active trading.
Highlights
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
We investigate the relationship between spot and futures contracts in the German electricity market, EEX (European Electricity Exchange), in terms of covariance and coherence, while analyzing hedge ratios at various time scales resorting to wavelet analysis
The present work differs from previous ones about hedging in electricity markets since we examine the relationship between spot and futures electricity markets over various time horizons using a recent empirical technique, wavelet analysis, employing a different testing methodology compared with previous studies that investigate spot and futures electricity markets relationships
Summary
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). Heterogeneous trading needs to be considered in the analysis of spot and futures price data in electricity markets and different hedging strategies need to take into account this different scale behavior. Attained results show that dynamic hedging strategies provide higher variance reductions in terms of hedging effectiveness, as compared to those attained by static ones, given the poor correlation between spot and futures prices in electricity markets, and a very different volatile behavior.
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