THE TECHNIQUES OF EXERCISING FUTURES AND FORWARDS BY THE HEDGING METHOD

Abstract

Supply and demand are always supposed to be balanced due to certain limitations relating to electricity. Electricity prices fluctuate constantly and cannot be determined with complete certainty. The spot market price of electricity is a reflection of the continuous equilibrium among the production and supply of electricity. Due to uncontrolled exposure to the risk of the continual fluctuations of the spot market prices, market participants can incur financial losses. For this purpose, future and forwards have been introduced on the market. Owing to them, market risk can be hedged by employing the hedging method. Two types of such contracts exist: futures traded on electricity exchanges and forwards traded on over-thecounter markets. In this article, the descriptions, differences and application of these contracts are presented. A description of the hedging method and its application to futures is provided. At the end of the article, an application of a futures contract on the largest Middle European electricity exchange, EEX, is presented.