Optimal dynamic hedging of electricity futures based on copula-GARCH models

The electricity futures market is an inevitable product from the development of electricity spot market, it is advantageous to discover the real price of electric power and reduce the risk of electricity market. This paper considers optimal dynamic hedging of electricity futures using copula-GARCH models. The Student's-t, Gumbel and time-varying normal copulas are utilized to capture the dependence structure between spot and futures of electricity, and the GARCH-t model is used to describe the marginal distribution and time-varying variance of spot and futures returns. Compared with conventional hedging strategies, including error correction model and dynamic conditional correlation GARCH model, the results show that copula-GARCH hedge ratios are quite effective in reducing risks in portfolio returns, and the Student's-t copula provides the best-performed hedge ratio for risk reduction.