Efficient hedging in an illiquid market
Vattenfall hedge its future electricity production in order to decrease fluctuations in theresult. Hedging can in a simplified way be described as selling the future electricity deliveriesin long-term contracts so that the future price of the delivery becomes fixed. The contractsused are electricity forwards traded at the Nordic electricity market Nord Pool. Animbalance between buyers and sellers can lead to a situation where the forward price notequals the expected spot price. The difference between the forward price and the expectedspot price is referred to as the market risk premium. This is the extra premium that marketparticipants are willing to pay to offset risk. Vattenfall?s production portfolio is one of thelargest in the Nordic region and the lack of liquidity at Nord Pool?s long-term contracts istherefore a limiting factor in effective risk management. The theory is that partly due to thelower liquidity in the longer contracts, Vattenfall pays an unfavorable risk premium in itslong term hedges (i.e. selling the electricity to a discount).In this master thesis the risk premia in the Nord Pool electricity market is measured. It isalso investigated if the risk premia changes with different time left to delivery. The resultsshow that the risk premia is positive for contracts entered close to delivery, i.e. the forwardprice exceeds the expected spot price. When time to delivery increases the risk premia decreasesand turns negative around one and a half year prior to delivery.The second part of this master thesis consists of an introduction and evaluation of ahedge strategy which is commonly referred to as rolling the hedge. This strategy is supposedto remove the negative effects of the long term negative risk premium. The conceptis to use two or more short-term contracts instead of a long-term contract. In this way thenegative risk premium is avoided. This can be done because the price movements of theshort-term contracts are correlated with the long-term contracts so that the result is protectedin the same way as with a long-term contract. However less than perfect whichmeans that the volatility (i.e. the risk) will increase.To investigate whether this strategy, in an efficient way, can be applied to increase theexpected return without a significant increase in risk, the outcome of the strategy in termsof risk and return from several different starting points are calculated with actual historicalprice data.It is showed, although the significance of the result should be interpreted with caution,that the expected return of the combined spot delivery and hedge program can be increasedwithout any major increase in the volatility of the returns.