Minimal Variance Hedging of Natural Gas Derivatives in Exponential Levy Models: Theory and Empirical Performance
33 Pages Posted: 13 Sep 2012
Date Written: September 12, 2012
Abstract
We consider the problem of hedging European options written on natural gas futures, in a market where prices of traded assets exhibit jumps, by trading in the underlying asset. We provide a general expression for the hedging strategy which minimizes the variance of the terminal hedging error, in terms of stochastic integral representations of the payoffs of the options involved. This formula is then applied to compute hedge ratios for common options in various models with jumps, leading to easily computable expressions. As a benchmark we take the standard Black-Scholes-Merton delta hedges. We show that in natural gas option markets minimal variance hedging with underlying consistently outperform the benchmarks by quite a margin.
Keywords: Quadratic hedging, jump-diffusions models, natural gas options, energy derivatives, resource economics
JEL Classification: G12, Q49
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