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VALENCIAN INSTITUTE OF ECONOMIC RESEARCH

EC series Working Papers

WP-EC 2017-01

Hedging spark spread risk with futures

Beatriz Martínez Martínez and Hipòlit Torró Enguix

Abstract

This is the first paper to discuss the spark spread risk management using electricity and natural gas futures. We focus on three European markets in which the natural gas share in the fuel mix varies considerably: Germany, the United Kingdom, and the Netherlands. We find that spark spread returns are partially predictable, and consequently, the Ederington and Salas (2008) minimum variance hedging approach should be applied. Hedging the spark spread is more difficult than hedging electricity and natural gas price risks with individual futures contracts. Whereas spark spread risk reduction for monthly periods produces values of between 20.05 and 48.90 per cent, electricity and natural gas individual hedges attain reductions ranging from 31.22 to 69.06 per cent. Results should be of interest for agents in those markets in which natural gas is part of the fuel mix in the power generation system.

Keywords: natural gas market, electricity market, futures contracts, forward contracts, spark spread, hedging ratio, seasonal effects.

JEL classification: G11, G13, L94, L95

DOI: http://dx.medra.org/10.12842/WPASEC-2017-01

 

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