A Utility Based Approach to Energy Hedging

TL;DR

This paper explores how different utility functions influence energy hedge strategies by incorporating market-based risk aversion, revealing significant variations in optimal hedging approaches.

Contribution

It introduces a method to incorporate energy market risk aversion into various utility functions for more tailored hedging strategies.

Findings

Significant differences in hedge strategies based on utility function choice

Market-based risk aversion impacts optimal hedge calculations

Comparison of log, exponential, and quadratic utility functions

Abstract

A key issue in the estimation of energy hedges is the hedgers' attitude towards risk which is encapsulated in the form of the hedgers' utility function. However, the literature typically uses only one form of utility function such as the quadratic when estimating hedges. This paper addresses this issue by estimating and applying energy market based risk aversion to commonly applied utility functions including log, exponential and quadratic, and we incorporate these in our hedging frameworks. We find significant differences in the optimal hedge strategies based on the utility function chosen.