Pricing and Hedging Illiquid Energy Derivatives: an Application to the JCC Index

In this paper we discuss a simple econometric 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 in price-levels, price first differences, 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 January 2000-January 2006. Third, we illustrate and implement a procedure to cross-hedge and price two different swaps on the JCC: a one-month swap and a three-month swap 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 sophisticated econometric techniques, since the price level regression model permits to compute a more reliable optimal hedge ratio relative to its competing alternatives.