Variance optimal hedging with application to Electricity markets

TL;DR

This paper develops an algorithm for variance optimal hedging in electricity markets, accounting for transaction costs and market illiquidity, demonstrating its effectiveness on real market data.

Contribution

It introduces a novel algorithm for mean-variance hedging that incorporates transaction costs and market depth considerations in electricity markets.

Findings

Effective hedging strategy demonstrated on electricity market data

Algorithm accounts for transaction costs and market illiquidity

Improves risk management in illiquid markets

Abstract

In Electricity markets, illiquidity, transaction costs and market price characteristics prevent managers to replicate exactly contracts. A residual risk is always present and the hedging strategy depends on a risk criterion chosen. We present an algorithm to hedge a position for a mean variance criterion taking into account the transaction cost and the small depth of the market. We show its effectiveness on a typical problem coming from the field of electricity markets.