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Formulating Hedging Strategies for Financial Risk Mitigation in Competitive U.S

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Formulating Hedging Strategies for Financial Risk Mitigation in Competitive U.S Scholars' Mine Masters Theses Student Theses and Dissertations Spring 2008 Formulating hedging strategies for financial risk mitigation in competitive U.S. electricity markets Karthik Viswanathan Follow this and additional works at: https://scholarsmine.mst.edu/masters_theses Part of the Systems Engineering Commons Department: Recommended Citation Viswanathan, Karthik, "Formulating hedging strategies for financial risk mitigation in competitive U.S. electricity markets" (2008). Masters Theses. 6832. https://scholarsmine.mst.edu/masters_theses/6832 This thesis is brought to you by Scholars' Mine, a service of the Missouri S&T Library and Learning Resources. This work is protected by U. S. Copyright Law. Unauthorized use including reproduction for redistribution requires the permission of the copyright holder. For more information, please contact [email protected]. FORMULATING HEDGING STRATEGIES FOR FINANCIAL RISK MITIGATION IN COMPETITIVE U.S. ELECTRICITY MARKETS by KARTHIK VISWANATHAN A THESIS Presented to the Faculty of the Graduate School of the UNIVERSITY OF MISSOURI - ROLLA In Partial Fulfillment of the Requirements for the Degree MASTER OF SCIENCE IN SYSTEMS ENGINEERING 2008 Approved by _______________________________ _______________________________ David Enke, Advisor Cihan Dagli _______________________________ Badrul Chowdhury © 2008 Karthik Viswanathan All Rights Reserved iii ABSTRACT In the competitive electricity industry, there exists some level of price risk for electricity in the form of price volatility. In order to perform efficient risk mitigation, it is necessary to have a good understanding on the future electricity demand and volatility. Electricity demand forecasting which drives the demand for fuels is first discussed. A method to predict future demand levels of electricity using a single factor mean reversion model is proposed. GARCH (1, 1) model is then used for forecasting the future daily volatility in demand. Both models use historical data for their simulations. The models, analysis methodology, data, and numerical results are discussed in this thesis. Modeling and simulation of risk is a key part of systems engineering. A risk mitigation framework that incorporates two cross-hedging strategies for reducing power price risk is proposed. The first strategy is a financial hedging strategy that involves taking one position in the cash market and an opposite position in the futures market. The second strategy involves the hedging of a physical delivery, which in this example involves taking two different positions in the electricity forward and natural gas futures markets such that the loss in one position will be offset by the gain in the other position. The risk is quantified in dollar terms for different risky scenarios, and the hedging strategies are simulated. To conclude, the two proposed hedging strategies are compared and the results of the mathematical modeling approaches are discussed in the final section The results indicates two key features: Hedging results in the stabilization of the expected profit margin and it also reduces the upward potential to profit from favorable market movements. iv ACKNOWLEDGMENTS I would like to express the deepest appreciation and thankfulness to my advisor and committee chair, Dr. David Enke, who taught me the financial engineering concepts and continually guided me to complete this research work. Without his guidance and persistent help, this thesis would not have been possible. I would like to thank my committee members, Dr. Cihan Dagli and Dr. Badrul Chowdhury, for their support and assistance in the preparation of this thesis. In addition, special thanks are due to my student friends, who have helped me with their clarifications that I requested on the mathematical approaches and understanding of the subject. I would like to thank the Intelligent Systems Center (ISC) of the University of Missouri – Rolla, along with the department of Engineering Management and Systems Engineering for their financial assistance. I also thank my father and mother for their valuable moral support and encouragement to accomplish this thesis work. v TABLE OF CONTENTS Page ABSTRACT.......................................................................................................................iii ACKNOWLEDGMENTS ................................................................................................. iv LIST OF ILLUSTRATIONS............................................................................................ vii LIST OF TABLES...........................................................................................................viii SECTION 1. INTRODUCTION...................................................................................................... 1 1.1. ELECTRICITY DEMAND AND VOLATILITY.............................................. 1 1.2. RISK MODEL USING CROSS-HEDGING STRATEGIES............................. 2 1.3. NATURAL GAS FUTURES MARKET............................................................ 4 2. OVERVIEW OF THE COMPETITIVE ELECTRICITY INDUSTRY .................... 6 2.1. DESCRIPTION OF MARKET PARTICIPANTS ............................................. 6 2.1.1. Generation Companies (GENCO)............................................................ 6 2.1.2. Load Serving Entities (LSE).. .................................................................. 6 2.1.3. Power Marketers....................................................................................... 6 2.1.4. Exchange and Market Makers.................................................................. 7 2.1.5. Independent System Operators................................................................. 7 2.2. ELECTRICITY MARKETS............................................................................... 7 2.2.1. The Spot Market....................................................................................... 7 2.2.2. The Physical Forward Market.. ................................................................ 8 2.2.3. The Financial Futures Market.. ................................................................ 9 2.2.4. The Derivatives Markets.. ........................................................................ 9 3. PROBLEM DEFINITION AND MODELING APPROACH ................................. 10 3.1. PROBLEM DEFINITION................................................................................ 10 3.2. NEED STATEMENT ....................................................................................... 11 3.3. MODELING APPROACH............................................................................... 11 4. FORECASTING MONTH-AHEAD ELECTRICITY DEMAND .......................... 13 4.1. FORECASTING LONG-RUN AVERAGE DEMAND .................................. 13 4.1.1. Mean Reversion Model.. ........................................................................ 13 vi 4.1.2. Methodology. ......................................................................................... 14 4.1.3. Mean Reversion Parameters Estimation................................................. 16 4.2. DATA AND NUMERICAL RESULTS OF STUDY ...................................... 16 4.2.1. Data.. ...................................................................................................... 16 4.2.2. Mean Reversion Model Results.. ........................................................... 16 5. FORECASTING VOLATILITY IN THE ELECTRICITY DEMAND .................. 20 5.1. FORECASTING DEMAND VOLATILITIES ................................................ 20 5.1.1. GARCH (1, 1) Model............................................................................. 20 5.1.2. Methodology. ......................................................................................... 21 5.2. DATA AND NUMERICAL RESULTS OF STUDY ...................................... 22 5.2.1. Data.. ...................................................................................................... 22 5.2.2. GARCH (1, 1) Model Results.. .............................................................. 22 6. HEDGING STRATEGIES FOR FINANCIAL RISK MITIGATION .................... 25 6.1. RISK MITIGATION ........................................................................................ 25 6.1.1. Risk Mitigation Framework.. ................................................................. 25 6.1.2. Case Study – Risk Mitigation by Hedging............................................. 26 6.1.2.1 Quantify risk.. .............................................................................26 6.1.2.2 Formulate algorithm....................................................................28 6.1.2.3 Financial hedge – no physical delivery of the asset....................29 6.1.2.4 Physical hedge – physical delivery of the asset..........................33 6.2. DISCUSSION................................................................................................... 37 7. CONCLUSION AND FUTURE RESEARCH ........................................................ 38 7.1. CONCLUSION................................................................................................. 38 7.2. DISCUSSION................................................................................................... 39 7.3. FUTURE RESEARCH ..................................................................................... 40 APPENDIX......................................................................................................................
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