Quadratic Hedging of Commodity and Energy Cash Flows

Nicola Secomandi

Foundations and Trends(R) in Technology, Information and Operations Management, 2019, vol. 12, issue 2-3, 240-253

Abstract: Commodity and energy prices are notoriously volatile. Firms routinely trade financial contracts to hedge their cash flows that are exposed to this source of risk. When markets are incomplete, which is typical in practice, eliminating such risk is impossible and attention must thus shift to its partial mitigation. This paper reviews quadratic hedging, which is an appealing financial risk management approach for this setting, considering a single commodity or energy cash flow that occurs on a given future date and assuming that financial hedging is based on trading a risk less bond and a futures contract. This work formulates this hedging problem as a Markov decision process, derives the optimal policy using stochastic dynamic programming, and characterizes the initial optimal bond position. Further, it highlights related current and potential future research.

Keywords: Risk management; Hedging; Operational risk; Supply chain finance (search for similar items in EconPapers)
JEL-codes: G32 M11 (search for similar items in EconPapers)
Date: 2019
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Citations: View citations in EconPapers (5)

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Persistent link: https://EconPapers.repec.org/RePEc:now:fnttom:0200000089

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