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Quadratic Hedging of Commodity and Energy Cash Flows

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  • Secomandi, Nicola

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.

Suggested Citation

  • Secomandi, Nicola, 2019. "Quadratic Hedging of Commodity and Energy Cash Flows," Foundations and Trends(R) in Technology, Information and Operations Management, now publishers, vol. 12(2-3), pages 240-253, March.
    • Handle: RePEc:now:fnttom:0200000089
    DOI: 10.1561/0200000089
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    References listed on IDEAS

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    Cited by:

    1. Jiao Wang & Lima Zhao & Arnd Huchzermeier, 2021. "Operations‐Finance Interface in Risk Management: Research Evolution and Opportunities," Production and Operations Management, Production and Operations Management Society, vol. 30(2), pages 355-389, February.
    2. Anna Maria Gambaro & Nicola Secomandi, 2021. "A Discussion of Non‐Gaussian Price Processes for Energy and Commodity Operations," Production and Operations Management, Production and Operations Management Society, vol. 30(1), pages 47-67, January.
    3. Secomandi, Nicola, 2022. "Quadratic hedging of risk neutral values," Energy Economics, Elsevier, vol. 112(C).
    4. Sheridan Titman, 2021. "Risk Transmission Across Supply Chains," Production and Operations Management, Production and Operations Management Society, vol. 30(12), pages 4579-4587, December.
    5. Nicola Secomandi, 2020. "Quadratic Hedging and Optimization of Option Exercise Policies," Papers 2001.05788, arXiv.org, revised May 2022.

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    More about this item

    Keywords

    Risk management; Hedging; Operational risk; Supply chain finance;
    All these keywords.

    JEL classification:

    • G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill
    • M11 - Business Administration and Business Economics; Marketing; Accounting; Personnel Economics - - Business Administration - - - Production Management

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