A new approach to evaluating the cost-efficiency of complex hedging strategies: an application to electricity price–volume quanto contracts

Sang Baum Kang, Michael Ong and Jialin Zhao

Abstract

Electricity quanto contracts improve the efficiency of financial risk management by accommodating the correlated price and volumetric risks of energy suppliers. The use of electricity quanto contracts, however, suffers from the high risk premiums associated with such tailor-made and illiquid financial instruments. As a result, it is of great interest to properly evaluate the cost-efficiency of these complex hedging deals. To address this concern, we propose a new hedging assessment model, the economic value of the incremental expected shortfall (EVIES), from a cost-efficiency perspective. Using EVIES, we develop a Monte Carlo simulation-based hedging framework. This framework overcomes the limits of traditional models by not resting on risk neutrality, market completeness or unobservable inputs. In our numerical examples, we assume that a fictitious power supplier has access to electricity price derivatives, weather derivatives and electricity quanto contracts, and we show that our proposed model can be applied to (1) construct a cost-effective hedge against an electricity price–volume joint risk, (2) find a partial equilibrium for the valuation of electricity quanto contracts and (3) locate hedging solutions for achieving a specific risk management target.