Hedging Of Contracts Research Articles

Forward contracts and market power in an electricity market

Generators in a wholesale electricity market can exercise market power, but the existence of forward hedging contracts between consumers and generators mitigates this market power. In our model we look at the role of the consumers (retailers here) in offering forward contracts. To deal with the problem of why generators should enter into such contracts, we suppose that the retailer gives an incentive to the generators, quite apart from any risk premium. Even so the retailer can earn a higher profit than when there are no contracts. We show that, in some circumstances, contracts lead to social welfare maximization when consumer demand is price sensitive.

Call for Papers—Special Issue of Management Science: Interfaces of Operations and Finance

Recently, a growing number of Operations Management researchers have started to investigate the interface between the two fields leveraging the institutional richness of Operations Management research, and proposing ways to operationally hedge operational and competitive exposures not effectively handled through typical financial hedging contracts. It is now timely to compile state-of-theart research at the interface of Finance and Operations Management in a special issue of Management Science. Such research will capitalize on the richness of the two fields while exploiting gaps left in their interfaces, with clear objectives: • contributing to the theory of at least one of the fields, while rigorously representing knowledge of the other. • creating managerial insights, practical knowledge and/or tools that general managers and risk management practitioners can use in their decisions and applications. The goal of this call for papers is to include research that shows conditions under which a tighter integration of both functions within and across enterprises leads to higher value creation, while at the same time advances the knowledge and creates tools for enterprise risk management. We solicit contributions spanning a diverse set of topics and using rigorous methodological approaches as appropriate to the question under study (theoretical modeling, conceptual frameworks, empirical, survey research, experimental etc.). Topics we are interested in, but not limited to: • Joint financing and capacity-investment choices • Integrated financial and operational hedging • Risk issues in commodity procurement • Real-options valuation and hedging in operations management • Global risk-management in manufacturing • Supply-chain contracting • Cross-functional approaches to managing large project risks • Risk measures, performance evaluation and incentives • Managing disruption and catastrophic risks in global supply chains: Building the Resilient Enterprise • Insurance and supply chain risks • Managing global outsourcing risks • Cross-functional approaches to managing new product and technology development risks • Managing operational risks in the service sector (banking, entertainment, travel, rentals etc.) • Operationalizing supply-chain risk management • Risk aversion in supply-chain management • Revenue management: financial implications of capacity-planning and dynamic pricing strategies • Risk considerations in revenue management • Special topics in sectors such as financial services and energy and commodity trading Submitted papers should feature original research contributions, display the rigor emphasized in the editorial statement of Management Science, clearly articulate their managerial relevance, and obey the journal’s author guidelines. The review process will be handled by the guest editors and an ad-hoc set of associate editors representing the fields of Operations and Supply Chain Management, Operations Research, Financial Economics and Applied Finance, and Financial Engineering. Submissions are due by July 31, 2007. Publication of the special issue is expected in early 2009. Paper provisions and submission guidelines are available at http://mansci.pubs.informs.org/.

Optimal Supply Functions in Electricity Markets with Option Contracts and Non-smooth Costs

In this paper we investigate the optimal supply function for a generator who sells electricity into a wholesale electricity spot market and whose profit function is not smooth. In previous work in this area, the generator’s profit function has usually been assumed to be continuously differentiable. However in some interesting instances, this assumption is not satisfied. These include the case when a generator signs a one-way hedge contract before bidding into the spot market, as well as a situation in which a generator owns several generation units with different marginal costs. To deal with the non-smooth problem, we use the model of Anderson and Philpott, in which the generator’s objective function is formulated as a Stieltjes integral of the generator’s profit function along his supply curve. We establish the form of the optimal supply function when there are one-way contracts and also when the marginal cost is piecewise smooth.

Measuring market power in electricity generation: A long-term perspective using a programming model

This paper focuses on measuring the extent to which market power has been exercised in a recently deregulated electricity generation sector. Our study emphasises the need to consider the concept of market power in a long-run dynamic context. A market power index is constructed focusing on differences between actual market returns and long-run competitive returns, estimated using a programming model devised by the authors. The market power implications of hedge contracts are briefly considered. The state of Queensland Australia is used as a context for the analysis. The results suggest that generators have exercised significant market power since deregulation.

Financial versus operative hedging of currency risk

Corporate risk management may employ financial or operative means to reduce the exposure to unexpected currency fluctuations. This article utilizes a real options framework to establish that operative hedging through the creation of operational flexibility represents a strategic complement to any variance-minimizing financial hedge. In addition, operational flexibility creates an asymmetric exposure profile and, as a result, alters the composition of the financial hedge portfolio. It alters the number of symmetric hedge contracts employed as well as their contractual rate and provides an economic argument for the use of (exotic) currency options. Operational flexibility acts as a value driver and may therefore be utilized, independent of its usefulness for risk management. The analysis further shows that operative hedging entails an implicit opportunity cost in the form of foregone option value.

Using high, low, open, and closing prices to estimate the effects of cash settlement on futures prices

Due to dwindling commercial interest in the feeder cattle futures contract, the Chicago Mercantile Exchange (CME) decided to replace the contract's physical delivery provision with a cash settlement provision, arguing that cash settlement would help reduce price volatility and attracts more commercial interests. In this article, we apply stochastic volatility models to investigate the CME conjecture, using four different estimators based on opening, high, low, and closing prices, respectively. With each estimator, we find that the volatility of the feeder cattle futures price decreases after the implementation of cash settlement. We conclude that the change in the contract specification enhances price discovery and the contract's hedging performance.

Excessive Price Volatility in the California Ancillary Services Markets: Causes, Effects, and Solutions

An analysis suggests that price volatility has been caused by generators' exercise of market power. The response by the California ISO has included the imposition of a fixed price cap and reforms intended to curb market power; but mechanisms used in other restructured electricity markets could have been considered, such as threats of regulatory action and use of hedge contracts.

An Empirical Analysis of the Impact of Hedge Contracts on Bidding Behavior in a Competitive Electricity Market*

A major concern in the design of wholesale electricity markets is the potential for the exercise of market power by generating unit owners. To better understand the determinants of generating unit owner market power and how it is exercised, this paper derives a model of bidding behavior in a competitive electricity market which incorporates various sources of uncertainty and the impact of the electricity generator's position in the financial hedge contract market on its expected profit-maximizing bidding behavior. The model is first used to characterize the profit-maximizing market price that a generator would like set by its bidding strategy for several hedge contract and spot sales combinations. This model is applied to bid and contract data obtained from the first three months of operation of the National Electricity Market (NEM1) in Australia. This analysis illustrates the sensitivity of expected profit-maximizing bidding strategies to the amount of financial hedge contracts held by the generating unit owner. It also provides strong evidence for the effectiveness of financial hedge contracts as a means to mitigate market power during the initial stages of operation of a wholesale electricity market. [L 94]

Production Organisation and Risk Control When Market Instruments Are Available

A standard result in the theory of production under price risk is that if forward cover is available, production is determined in terms of the known, quoted forward or futures price, rather than expectations of future prices. In practice, however, primary production often involves joint or substitutable products, so that a natural hedge may be available. In addition, costs such as input prices or interest rates are highly variable and may be correlated with output prices. Supply risk adds to this variation. This paper considers the demand for market-based hedging instruments in relation to such natural hedges and to the possible use of storage for hedging purposes. Under normality of conditional price/cost variation it is shown that for relatively arbitrary nonlinear production technologies and attitudes to risk, producers can plan production and derive their demand for futures by decomposing the organisation into a number of activity centres, involving planning, marketing, cost, and treasury functions. Adding up the hedging demands from each centre, and equating to the effective supply of each type of hedge (natural and market), yields a linear system that may be solved for the optimum quantities of each hedge contract.

Portfolio insurance for foreign exchange risk management

Since the advent of floating exchange rates in the early 1970s management of exchange exposure has received much attention. Adler and Dumas [1, 21 and Dufey and Srinivasulu [14] contend that, because of imperfect markets for real goods and services and financial assets, exchange rate risk is relevant. Because of informational inefficiencies, exchange rate risk should be managed at the corporate rather than the shareholder level. Logue and Oldfield [22] and others suggest that hedging should be focused on cash flow rather than financial statement exposure. Several studies have evaluated and compared hedging alternatives that employ currency forward or futures contracts. Hill and Schneeweis 1191 compared the hedging capabilities of forward and futures contracts, finding no significant differences for the Deutschmark or British pound, but superior forward hedging for the Japanese yen. Babbel[5] used a mean-variance approach to compare the hedging effectiveness of the forward hedge and the money market hedge, Calderon-Rossel [12] provided a framework for choosing between either of these alternatives or not hedging. Swanson and Caples (291, Grammatikos [17], and others attempt to determine the optimal hedge ratio in currency futures and forward markets. Chang and Shanker [13] show that a synthetic futures contract generally exhibits less hedging effectiveness than currency futures contracts. And Eun and Resnick 1151, examining the hedging of interna~on~y diversified stock portfolios, report that substantial reductions in exchange rate risk obtain via forward contract hedging. While forward, futures, and ~ternational money market hedges effectively remove downside exchange risk, they also preclude the possibility of upside potential when exchange rates move in a favorable direction. An alternative