The Incremental Expected Shortfall-Based Pricing: Application to a Cost-Effective Hedge of an Electricity Price-Volume Quanto Risk
2016
To evaluate complex hedging deals from a
cost-efficiencyperspective, this paper proposes a new hedging-effectiveness
measure, the
EconomicValue of the Incremental
Expected Shortfall(EV-IES), which summarizes the costs and benefits of a hedging strategy by taking into account firm-specific and
observable variablessuch as the
weighted average costof
capitaland the marginal
corporate taxrate. The EV-IES, shown to be monotonic, concave, and scale-invariant, offers an intuitive and clear guideline regarding acceptance/rejection of a proposed hedging deal. To illustrate the application of the EV-IES, our empirical study considers a fictitious Chicago-based
electricity load-serving entity facing a price-volume joint risk. Using
electricity pricederivatives,
weather derivatives, and tailor-made electricity-temperature
quantity-adjusting(
quanto) contracts, we illustrate how to find an optimally
cost-efficienthedging strategy, a
break-evenpremium for
quantocontracts, and a hedging strategy for achieving a firm's target
expected shortfalllevel.
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