Time-varying risk aversion : an application to energy hedging

Risk aversion is a key element of utility maximizing hedge strategies; however, it hastypically been assigned an arbitrary value in the literature. This paper instead applies a GARCH-in-Mean (GARCH-M) model to estimate a time-varying measure of riskaversion that is based on the observed risk preferences of energy hedging marketparticipants. The resulting estimates are applied to derive explicit risk aversion basedoptimal hedge strategies for both short and long hedgers. Out-of-sample results arealso presented based on a unique approach that allows us to forecast risk aversion,thereby estimating hedge strategies that address the potential future needs of energyhedgers. We find that the risk aversion based hedges differ significantly from simplerOLS hedges. When implemented in-sample, risk aversion hedges for short hedgersoutperform the OLS hedge ratio in a utility based comparison.