Energy Commodities: A Review of Optimal Hedging Strategies

Energy is considered as a commodity nowadays and continuous access along with price stability is of vital importance for every economic agent worldwide. The aim of the current review paper is to present in detail the two dominant hedging strategies relative to energy portfolios, the Minimum-Variance hedge ratio and the expected utility maximization methodology. The Minimum-Variance hedge ratio approach is by far the most popular in literature as it is less time consuming and computationally demanding; nevertheless by applying the appropriate multivariate model Garch family volatility model, it can provide a very reliable estimation of the optimal hedge ratio. However, this becomes possible at the cost of a rather restrictive assumption for infinite hedger’s risk aversion. Within an uncertain worldwide economic climate and a highly volatile energy market, energy producers, retailers and consumers had to become more adaptive and develop the necessary energy risk management and optimal hedging strategies. The estimation gap of an optimal hedge ratio that would be subject to the investor’s risk preferences through time is filled by the relatively more complex and sophisticated expected utility maximization methodology. Nevertheless, if hedgers share infinite risk aversion or if alternatively the expected futures price is approximately zero the two methodologies become equivalent. The current review shows that when evidence from the energy market during periods of extremely volatile economic climate is considered, both hypotheses can be violated, hence it becomes reasonable that especially for extended hedging horizons it would be wise for potential hedgers to take into consideration both methodologies in order to build a successful and profitable hedging strategy.