Time varying risk aversion : an application to energy hedging

Risk aversion is a key element of utility maximizing hedge strategies; however, it has
typically 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 risk
aversion that is based on the observed risk preferences of energy hedging market
participants. The resulting estimates are applied to derive explicit risk aversion based
optimal hedge strategies for both short and long hedgers. Out-of-sample results are
also presented based on a unique approach that allows us to forecast risk aversion,
thereby estimating hedge strategies that address the potential future needs of energy
hedgers. We find that the risk aversion based hedges differ significantly from simpler
OLS hedges. When implemented in-sample, risk aversion hedges for short hedgers
outperform the OLS hedge ratio in a utility based comparison.