TITLE:
An Analytic Hedging Model of Energy Quanto Contracts
AUTHORS:
Sang Baum Kang, Jialin Zhao
KEYWORDS:
Energy Quanto Contract, Financial Risk Management, Complex Derivative, Electricity Market, Energy Finance
JOURNAL NAME:
Theoretical Economics Letters,
Vol.7 No.4,
June
7,
2017
ABSTRACT: Earnings of energy firms are exposed to a joint risk
of energy price and energy consumption. The correlated fluctuations in both
price and consumption present a joint risk of price and volume for a
load-serving entity (LSE). In order to manage such a joint risk, LSEs take
positions in a variety of hedging contracts. Among these financial instruments,
we analyze the use of electricity-temperature quantity-adjusting (quanto)
contracts. In this paper, we consider an LSE that has access to electricity
price derivatives, temperature derivatives, and energy quanto contracts. We
derive the closed-form optimal hedging positions in these contracts and the
optimal mean-variance tradeoff, from an analytic model that we develop within
the Constant Absolute Risk Aversion (CARA)-normal setting. We mathematically
prove that the use of quanto contracts allows an LSE to lower its revenue
volatility. Furthermore, our model offers novel economic insights into the
application of energy quanto contracts to hedging practice. First, we document
and quantify the “dirty hedge” of standardized price and temperature
derivatives in the absence of tailor-made energy quanto contracts. Second, we
derive a threshold price of energy quanto contracts. If an energy quanto
contract is quoted above this threshold price, an LSE shall not trade such a
contract for risk management purposes. Third, this paper investigates a
questionable, yet commonly adopted practice of using temperature as a perfect
proxy for power consumption.