Epsilon Archive for Student Projects

Abstract

Vattenfall hedge its future electricity production in order to decrease fluctuations in the
result. Hedging can in a simplified way be described as selling the future electricity deliveries
in long-term contracts so that the future price of the delivery becomes fixed. The contracts
used are electricity forwards traded at the Nordic electricity market Nord Pool. An
imbalance between buyers and sellers can lead to a situation where the forward price not
equals the expected spot price. The difference between the forward price and the expected
spot price is referred to as the market risk premium. This is the extra premium that market
participants are willing to pay to offset risk. Vattenfall’s production portfolio is one of the
largest in the Nordic region and the lack of liquidity at Nord Pool’s long-term contracts is
therefore a limiting factor in effective risk management. The theory is that partly due to the
lower liquidity in the longer contracts, Vattenfall pays an unfavorable risk premium in its
long term hedges (i.e. selling the electricity to a discount).

In this master thesis the risk premia in the Nord Pool electricity market is measured. It is
also investigated if the risk premia changes with different time left to delivery. The results
show that the risk premia is positive for contracts entered close to delivery, i.e. the forward
price exceeds the expected spot price. When time to delivery increases the risk premia decreases
and turns negative around one and a half year prior to delivery.

The second part of this master thesis consists of an introduction and evaluation of a
hedge strategy which is commonly referred to as rolling the hedge. This strategy is supposed
to remove the negative effects of the long term negative risk premium. The concept
is to use two or more short-term contracts instead of a long-term contract. In this way the
negative risk premium is avoided. This can be done because the price movements of the
short-term contracts are correlated with the long-term contracts so that the result is protected
in the same way as with a long-term contract. However less than perfect which
means that the volatility (i.e. the risk) will increase.

To investigate whether this strategy, in an efficient way, can be applied to increase the
expected return without a significant increase in risk, the outcome of the strategy in terms
of risk and return from several different starting points are calculated with actual historical
price data.

It is showed, although the significance of the result should be interpreted with caution,
that the expected return of the combined spot delivery and hedge program can be increased
without any major increase in the volatility of the returns.