Using electricity options to hedge against financial risks of power producers

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A hedge is an investment position intended to offset potential losses or gains that may be incurred by a companion investment.

In simple language, a hedge is a risk management technique used to reduce any substantial losses or gains suffered by an individual or an organization. A hedge can be constructed from many types of financial instruments, including stocksexchange-traded fundscommodity options trading and hedging pdf viewerforward contractsswapsoptionsgambles, [1] many types of over-the-counter and derivative products, and futures contracts. Public futures markets were established in the 19th century [2] to allow transparent, standardized, and efficient hedging of agricultural commodity prices; they have since expanded to include commodity options trading and hedging pdf viewer contracts for hedging the values of energyprecious metalsforeign currencyand interest rate fluctuations.

Hedging is the practice of taking a position in one market to offset and balance against the risk adopted by assuming a position in a contrary or opposing market or investment.

The word hedge is from Old English hecgoriginally any fence, living or artificial. The use of the word as a verb in the sense of "dodge, evade" is first recorded in the s; that of insure oneself commodity options trading and hedging pdf viewer loss, as in a bet, is from the s. A typical hedger might be a commercial farmer.

The market values of wheat and other crops fluctuate constantly as supply and demand for them vary, with occasional large moves in either direction. Based on current prices and forecast levels at harvest time, the farmer might decide that planting wheat is a good idea one season, but the price of wheat might change over time. Once the farmer plants wheat, he is committed to it for an entire growing season. If the actual price of wheat rises greatly between planting and harvest, the farmer stands to make a lot of unexpected money, but if the actual price drops by harvest time, he is going to lose the invested money.

Due to the uncertainty of future supply and demand fluctuations, and the price risk imposed on the farmer, said farmer may use different financial transactions to reduce, or hedge, their risk. One such transaction is the use of forward contracts. Forward commodity options trading and hedging pdf viewer are mutual agreements to deliver a certain amount commodity options trading and hedging pdf viewer a commodity at a certain date for a specified price and each contract is unique to the buyer and seller.

For this example, the farmer can sell a number of forward contracts equivalent to the amount of wheat he expects to harvest and essentially lock in the current price of wheat.

Once the forward contracts expire, the farmer will harvest the wheat and deliver it to the buyer at the price agreed to in the forward contract. Therefore, the farmer has reduced his risks to fluctuations in the market of wheat because he has already guaranteed a certain number of bushels for a certain price.

However, there are still many risks associated with this type of hedge. For example, if the farmer has a low yield year and he harvests less than the amount specified in the forward contracts, he must purchase the bushels elsewhere in order to fill the contract. This becomes even more of a problem when the lower yields affect the entire wheat industry and the price of wheat increases due to supply and demand pressures. Also, while the farmer hedged all of the risks of a price decrease away by locking in the price with a forward contract, he also gives up the right to the commodity options trading and hedging pdf viewer of a price increase.

Another risk associated with the forward contract is the risk of default or renegotiation. The forward contract locks in a certain amount and price at a certain future date. Because of that, there is always the possibility that the buyer will not pay the amount required at the end of the contract or that the buyer will try to renegotiate the contract before it expires. Future contracts are another way our farmer can hedge his risk without a few of the risks that forward contracts have.

Future contracts are similar to forward contracts except they are more standardized i. These contracts trade on exchanges and are guaranteed through clearinghouses. Clearinghouses ensure that every contract is honored and they take the opposite side of every contract.

Future contracts typically are more liquid than forward contracts and move with the market. Because of this, the farmer can minimize the risk he faces in the future through the selling of future contracts.

Future contracts also differ from forward contracts in that delivery never happens. The exchanges and clearinghouses allow the buyer or seller to leave the contract early and cash out.

So tying back into the farmer selling his wheat at a future date, he will sell short futures contracts for the amount that he predicts to harvest to protect against a price decrease. The current spot price of wheat and the price of the futures contracts for wheat converge as time gets closer to the delivery date, so commodity options trading and hedging pdf viewer order to make money on the hedge, the farmer must close out his position earlier than then.

On the chance commodity options trading and hedging pdf viewer prices decrease in the future, the farmer will make a profit on his short position in the futures market which offsets any decrease in revenues from the spot market for wheat.

On the other hand, if prices increase, the farmer will generate a loss on the futures market which is offset by an increase in revenues on the spot market for wheat.

Instead of agreeing to sell his wheat to one person on a set date, the farmer will just buy and sell futures on an exchange and then sell his wheat wherever he wants once he harvests it. A stock trader believes that the stock price of Company A will rise over the next month, due to the company's new and efficient method of producing widgets.

He wants to buy Company A shares to profit from their expected price increase, as he believes that shares are currently commodity options trading and hedging pdf viewer.

But Company A is part of a highly volatile widget industry. So there is a risk of a future event that affects stock prices across the whole industry, including commodity options trading and hedging pdf viewer stock of Company A along with all other companies. Since the trader is interested in the specific company, rather than the entire industry, he wants to hedge out the industry-related risk by short selling an equal value of shares from Company A's direct, yet weaker competitorCompany B.

The first day the trader's portfolio is:. If the trader was able to short sell an asset whose price had a mathematically defined relation with Company A's stock price for example a put option on Company A sharesthe trade might be essentially riskless. In this case, the risk would be limited to the put option's premium.

On the second day, a favorable news story about the widgets industry is published and the value of all widgets stock goes up. The trader might regret the hedge on day two, since it reduced the profits on the Company A position.

But on the third day, an unfavorable news story is published about the health effects of widgets, and all widgets stocks crash: Nevertheless, since Company A is the better company, it suffers less than Company B:.

The introduction of stock market index futures has provided a second means of hedging risk on a single stock by selling short the market, as opposed to another single or selection of stocks. Futures are generally highly fungible and cover a wide variety of potential investments, which makes them easier to use than trying to find another stock which somehow represents the opposite of a selected investment.

Employee stock options ESOs are securities issued by the company mainly to its own executives and employees. These securities are more volatile than stocks.

An efficient way to lower the ESO risk is to sell exchange traded calls and, to a lesser degree, [ clarification needed ] to buy puts. Companies discourage hedging the ESOs but there commodity options trading and hedging pdf viewer no prohibition against it. Airlines use futures contracts and derivatives to hedge their exposure to the price of jet fuel. They know that they must purchase jet fuel for as long as they want to stay in business, and fuel prices are notoriously volatile.

By using crude oil futures contracts to hedge their fuel requirements and engaging in similar but more complex derivatives transactionsSouthwest Airlines was able to save a large amount of money when buying fuel as compared to rival airlines when fuel prices in the U. As an emotion regulation strategy, people can bet against a desired outcome.

A New England Patriots fan, for example, could bet their opponents to win to reduce the negative emotions felt if the team loses a game. People typically do not bet against desired outcomes that are important to their identity, due to negative signal about their identity that making such a gamble entails. Betting against your team or political candidate, for example, may signal to you that you are not as committed to them as you thought you were.

Hedging can be used in many different ways including foreign exchange trading. The stock example above is a "classic" sort of hedge, known in the industry as a pairs trade due to the trading on a pair of related securities. As investors became more sophisticated, along with the mathematical tools used to calculate values known as modelsthe types of hedges have increased greatly. Examples of hedging include: A hedging strategy usually refers to the general risk management policy commodity options trading and hedging pdf viewer a financially and physically trading firm how to minimize their risks.

As the term hedging indicates, this risk mitigation is usually done by using financial instrumentsbut a hedging strategy as used by commodity traders like large energy companies, is usually referring to a business model including both financial and physical deals.

In order to show the difference between these strategies, let us consider the fictional company BlackIsGreen Ltd trading coal by buying this commodity at the wholesale market and selling it to households mostly in winter. Back-to-back B2B is a strategy where any open position is immediately closed, e. If BlackIsGreen decides to have a B2B-strategy, they would buy the exact commodity options trading and hedging pdf viewer of coal at the very moment when the household customer comes into their shop and signs the contract.

This strategy minimizes many commodity risksbut has the drawback that it has a large volume and liquidity riskas BlackIsGreen does not know how whether it commodity options trading and hedging pdf viewer find enough coal on the wholesale market to fulfill the need of the households.

Tracker hedging is a pre-purchase approach, where the open position is decreased the closer the maturity date comes. If BlackIsGreen knows that most of the consumers demand coal in winter to heat their house. A strategy driven by a tracker would now mean that BlackIsGreen buys e.

The closer the winter comes, the better are the weather forecasts and therefore the estimate, how much coal will be demanded by the households in the coming winter. A certain hedging corridor around the pre-defined tracker-curve is allowed and fraction of the open positions decreases as the maturity date comes closer. Delta-hedging mitigates the financial risk of an option by hedging against price changes in its underlying.

It is called like that as Delta is the first derivative of the option's value with respect to the underlying instrument 's price. This is performed in practice by buying a derivative with an inverse price movement. It is also a type of market neutral strategy.

Only if BlackIsGreen chooses to perform delta-hedging as strategy, actual financial instruments come into play for hedging in the usual, stricter meaning. Risk reversal means simultaneously buying a call option and selling a put option. This has the effect of simulating being long on commodity options trading and hedging pdf viewer stock or commodity position.

Many hedges do not involve exotic financial instruments or derivatives such as the married put. A natural hedge is an investment that reduces the undesired risk by matching cash flows i. For example, an exporter to the United States faces a risk of changes in the value of the U. Another example is commodity options trading and hedging pdf viewer company that opens a subsidiary in another country and borrows in the foreign currency to finance its operations, even though the foreign interest rate may be more expensive than in its home country: Similarly, an oil producer may expect to receive its revenues in U.

One common means of hedging against risk is the purchase of insurance to protect against financial loss due to accidental property damage or loss, personal injury, or loss of life. There are varying types of financial risk that can be protected against with a hedge. Those types of risks include:. Equity in a portfolio can be hedged by taking an opposite position in futures.

To protect your stock picking against systematic market riskfutures are shorted when equity is purchased, or long futures when stock is shorted. One way to hedge is the market neutral approach. In this approach, an equivalent dollar amount in the stock trade is taken in futures — for example, commodity options trading and hedging pdf viewer buying 10, GBP worth of Vodafone and shorting 10, worth of FTSE futures the index in which Vodafone trades.

Another way to hedge is the beta neutral. Beta is the historical correlation between a stock and an index.

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