Pricing and hedging illiquid energy derivatives: An application to the JCC index

Abstract

Standard-Nutzungsbedingungen:Die Dokumente auf EconStor dürfen zu eigenen wissenschaftlichen Zwecken und zum Privatgebrauch gespeichert und kopiert werden.Sie dürfen die Dokumente nicht für öffentliche oder kommerzielle Zwecke vervielfältigen, öffentlich ausstellen, öffentlich zugänglich machen, vertreiben oder anderweitig nutzen.Sofern die Verfasser die Dokumente unter Open-Content-Lizenzen (insbesondere CC-Lizenzen) zur Verfügung gestellt haben sollten, gelten abweichend von diesen Nutzungsbedingungen die in der dort genannten Lizenz gewährten Nutzungsrechte. Terms of use: Documents in Pricing and Hedging Illiquid Energy Derivatives: an Application to the JCC Index SummaryIn this paper we discuss a simple strategy for pricing and hedging illiquid financial products, such as the Japanese crude oil cocktail (JCC) index, the most popular OTC energy derivative in Japan. First, we review the existing literature for computing optimal hedge ratios (OHR) and we propose a critical classification of the existing approaches. Second, we compare the empirical performance of different econometric models (namely, regression models for price levels, price first differences, and price returns, as well as error correction and autoregressive distributed lag models) in terms of their computed OHR, using monthly data on the JCC over the period Janury 2000-January 2006. Third, we illustrate and implement a reliable procedure to price and hedge a swap contract on the JCC with a variable oil volume. We explain how to compute a bid/ask spread and to construct the hedging position for the JCC swap. Fourth, we evaluate our swap pricing scheme with backtesting and rolling regression techniques. Our empirical findings show that it is not necessary to use complicated econometric techniques, since the price-level regression model permits to compute more precise optimal hedge ratios relative to its competing alternatives.

Asian Spot Prices for LNG and other Energy Commodities

“…Financial analysts wanting to construct hedging instruments against JCC have investigated the relationship between JCC and spot market oil prices. For example, Scarpa and Manera (2008) suggest using the WTI as a hedging instrument for JCC. In light of the issues discussed in the previous footnote, Brent would be more appropriate than WTI in our sample period.…”