HEDGING WITH ELECTRICITY FUTURES Hedge Performance and Market Development in the Nordic Electricity Market

Abstract

This Master Thesis estimates and applies three various futures hedging strategies for the spot exposures at the Nordic electricity market. We compare the variance and hedging effectiveness of the traditional naïve hedge, the static Ordinary Least Squares (OLS) hedge, and the dynamic Constant Conditional Correlation GARCH (CCC-GARCH) hedge. The various hedging strategies are implemented on monthly- and quarterly futures contracts with different hedging durations. The key finding of our study is that futures contracts can reduce some price uncertainty compared to an unhedged position, even with the lack of straight forward arbitrage possibilities in the electricity market. The results indicate that dynamic hedge ratios can in some cases be more efficient than a static approach, when ARCH-effects are present. Furthermore, we find that an electricity producer will not benefit from hedging over a longer duration. The main reason for this is that that the correlation between spot- and futures returns are generally higher for the contracts with a shorter duration. This might indicate that noise in the Nordic electricity market is not cancelled over time. We find that both spot- and futures returns have developed to become even more volatile over the years, which may be explained by the market developing towards more renewable- and intermittent energy.