Liquidity and dirty hedging in the Nordic electricity market

Hedging involves tradeoffs in incomplete markets because the number of hedging instruments is limited. Even when an extensive set of hedging instruments is available, the ease with which these instruments can be traded may be highly variable. This study finds systematic variations in liquidity in different segments of the Nordic electricity swap market and analyzes the potential for replacing low-liquidity, delivery-period-matched hedging instruments with more liquid, delivery-period-mismatched hedging instruments. When the costs of implementing such dirty hedging strategies are lower than those of the replaced hedging instruments and the loss of hedge effectiveness is small, dirty hedging strategies may then replace their delivery-period-matched counterparts. In this context, I analyze the dynamic out-of-sample tracking performance of selected dirty hedges. Electricity swaps with delivery in front year one and two, respectively, track electricity swaps with delivery in front year three quite well. This suggests that hedge effectiveness can be traded off for the reduced costs of implementing these dirty hedging strategies compared with those of the less liquid year-three swaps.

► I analyze liquidity in different segments of the Nordic electricity swap market and find systematic variations in the ease with which different electricity swaps may be traded. ► Next, I analyze implications for firms' hedging strategies, namely, the potential for replacing low-liquidity, delivery-period-matched hedging instruments with more liquid, delivery-period-mismatched hedging instruments. ► The dynamic performance of selected "dirty hedges" suggest that hedge effectiveness can be traded off for the reduced costs of implementing the "dirty hedges" compared with those of the less liquid electricity swaps.