Multivariate volatility approaches for optimal and efficient hedge ratio: Empirical analysis of Turkish and UK electricity markets

One of the major transformations in the world economy is emerging out of integration processin the energy markets. An important feature of integration processis the structure of monopolistic competition and monopoly in terms of energy supply in global dimensions. Although, the energy-producing countries determine the spot prices in the electricity markets, they do not have dominationthe energy derivatives markets. This issue has become more important after the dramatic change in energy markets.With the growing size of the electricity market by combining the power lines traded between the countries,electricity has become a tradable good. The formation of the electricity market and the pricing mechanism is different from other financial markets. Althoguhelectricity is accepted as a tradeable good, electricity cannot be stored. Therefore, due to inability to stop the electricity production, there is a possibility to have negative electricity prices in the market. This situation leads to fluctuations in the electricity spot prices and hence raises the risks for producers and consumers. For this reason, countries with spot or retail electricity markets have established their electricity derivatives markets to hedge risks. Derivativescontracts are produced to protect against risks arising from the volatility of spot electricity prices. This situation led to portfolio diversification and hedging.In this way the new econometric techniques are developed to achieve optimal and efficient hedging strategies. In this study optimal and efficient hedge ratio is analyzedfor Turkish and UK Electricity Markets in the event of the same nature of said goods and/or contracts which are traded in different spot and futures markets. For this purpose relevant econometric techniques developed in the literature are briefly described and summarized. The econometric techniques with statistically significant results were selected to calculate optimal and efficient hedge ratio. In order to address the causal relationship between the volatility of the markets, Turkish and UK Electricity Market Prices have been analyzed with the empirical data used by two different econometric approaches. According to the empirical findings based on various multivariate volatility approaches, we conclude that the most appropriate approaches are the diagonal and VECH techniques for the case of Turkish and UK Electricity Markets. Keywords: Electricity Market, Optimal and Efficient Hedge Ratio, Multivariate GARCH, BEKK, CCC, DCC, Diagonal-VECH