Hedging Chaos and Randomness in Temperature and Energy Markets
by
Matt Davison
University of Western Ontario, Canada

Chaos in Dynamical Systems, with its concomitant lack of long-range predictability, is known to be amenable to mathematical treatment by the probabilistic tools used to analyse the stochastic differential equations of modern financial engineering. Stochastic differential equations having the martingale property are excellent tools for modeling financial markets because of the essentially social and self-correcting nature of such markets; chaos may well be a better descriptor of the weather upon which for instance electricity prices so heavily depend. In this talk we present some thoughts as to how hedging strategies for energy derivatives may be developed if the conceptual model of chaos in the short term, randomness in the long term is adopted. We also present an application of these thoughts to a successful risk arbitrage strategy on “momentum stocks” which was utilized by the author in the Canadian stock market ca. 1998.

Date received: March 14, 2007