Hedging strategies for energy derivatives

Abstract

In this article, we define a hedging strategy in a setting typical for the commodity market. Firstly, we prove the existence of the locally risk-minimizing (LRM) hedging strategy for payment streams in this setting. Next, a three-step procedure is described to determine the LRM hedging strategy. Then the procedure is illustrated for stochastic volatility models, as these models are a special case of the non-traded situation which frequently occurs in the commodity markets. Finally, we introduce the (adjusted) LRM hedging strategy in the non-traded setting and for this specific setting we numerically show the outperformance of this strategy compared with current market practices.