Market completeness: how options affect hedging and investments in the electricity sector.

The high volatility of electricity markets gives producers and retailers an incentive to hedge their exposure to electricity prices by buying and selling derivatives. This paper studies how welfare and investment incentives are affected when an increasing number of derivatives are introduced. It develops an equilibrium model of the electricity market with risk averse firms and a set of traded financial products, more specifically: a forward contract and an increasing number of options. We first show that aggregate welfare (the sum of individual firms' utility) increases with the number of derivatives offered, although most of the benefits are captured with one to three options. Secondly, power plant investments typically increase because additional derivatives enable better hedging of investments. However, the availability of derivatives sometimes leads to ‘crowding-out’ of physical investments because capital is being used more profitably to speculate on financial markets. Finally, we illustrate that players basing their investment decisions on risk-free probabilities inferred from market prices, may significantly overinvest when markets are not sufficiently complete.

Risk management in electricity markets: hedging and market incompleteness

The high volatility of electricity markets gives producers and retailers an incentive to hedge their exposure to electricity prices by buying and selling derivatives. This paper studies how welfare and investment incentives are affected when markets for derivatives are introduced, and to what extent this depends on market completeness. We develop an equilibrium model of the electricity market with risk-averse firms and a set of traded financial products, more specifically: forwards and an increasing number of options. Using this model, we first show that aggregate welfare in the market increases with the number of derivatives offered. If firms are concerned with large negative shocks to their profitability due to liquidity constraints, option markets are particularly attractive from a welfare point of view. Secondly, we demonstrate that increasing the number of derivatives improves investment decisions of small firms (especially when firms are risk-averse), because the additional financial markets signal to firms how they can reduce the overall sector risk. Also the information content of prices increases: the quality of investment decisions based on risk-free probabilities, inferred from market prices, improves as markets become more complete Finally, we show that government intervention may be needed, because private investors may not have the right incentives to create the optimal number of markets.

Risk management in electricity markets: hedging and market incompleteness.

The high volatility of electricity markets gives producers and retailers an incentive to hedge their exposure to electricity prices by buying and selling derivatives. This paper studies how welfare and investment incentives are affected when markets for derivatives are introduced, and to what extent this depends on market completeness. We develop an equilibrium model of the electricity market with riskaverse firms and a set of traded financial products, more specifically: forwards and an increasing number of options. Using this model, we first show that aggregate welfare in the market increases with the number of derivatives offered. If firms are concerned with large negative shocks to their profitability due to liquidity constraints, option markets are particularly attractive from a welfare point of view. Secondly, we demonstrate that increasing the number of derivatives improves investment decisions of small firms (especially when firms are risk-averse), because the additional financial markets signal to firms how they can reduce the overall sector risk. Also the information content of prices increases: the quality of investment decisions based on risk-free probabilities, inferred from market prices, improves as markets become more complete Finally, we show that government intervention may be needed, because private investors may not have the right incentives to create the optimal number of markets.

Strategic Pricing in Service Industries.

This dissertation studies several strategic-level pricing decisions of firms that are motivated by recent changes of pricing policies in several service industries. It consists of three essays, each analyzing a different problem of selecting the optimal pricing policy for firms in a certain service industry. All three essays contribute to the arising areas of strategic-level revenue management and consumer-driven operations management. The first essay studies whether preventing resale of tickets benefits the ticket providers for sporting and entertainment events. Different from what common wis- dom may suggest, I find that this event organizers can benefit from reductions in consumers’ (and speculators’) transaction costs of resale in many cases. Further, I propose ticket options (where consumers would initially purchase an option to buy a ticket and then exercise at a later date) as a novel ticket pricing policy, and show that ticket options naturally reduce ticket resale and increase event organizers’ revenues. The second essay studies a conditional upgrade strategy that has recently become common in the travel industry. A consumer can accept a conditional upgrade offer after making a reservation and pay the fee to upgrade at check-in if the higher-quality product type is still available. I identify multiple benefits of conditional upgrades including demand expansion, price correction, and risk management. Moreover, I find that using conditional upgrades can generate higher revenues than having the ability to optimize product prices and use dynamic pricing. The third essay studies the firm’s strategic decision of whether to bundle the an- cillary service (e.g., baggage delivery) into the main service (e.g., air travel) or to unbundle and charge separate prices. I find that a firm that can price-discriminate when selling the main service should unbundle the ancillary service because con- sumers’ likelihoods of purchasing the ancillary service are low, or a large proportion of consumers are myopic instead of forward-looking, or the firm is dependent on inter- mediaries to make sales. I also find that the firm’s ability to price-discriminate when selling the main service reverses some classic bundling results for a uniform-pricing firm.PhDBusiness AdministrationUniversity of Michigan, Horace H. Rackham School of Graduate Studieshttp://deepblue.lib.umich.edu/bitstream/2027.42/113531/1/cuiyao_1.pd

Learning about common and private values in oligopoly

We characterize a duopoly buffeted by demand and cost shocks. Firms learn about shocks from common observation, private observation, and noisy price signals. Firms internalize how outputs affect a rival's signal, and hence output. We distinguish how the nature of information —public versus private—and of what firms learn about—common versus private values—affect equilibrium outcomes. Firm outputs weigh private information about private values by more than common values. Thus, prices contain more information about private-value shocks

Forward Contracting and Collusion in Oligopoly

We consider an infinitely-repeated oligopoly in which at each period firms not only serve the spot market by either competing in prices or quantities but also have the opportunity to trade forward contracts. Contrary to the pro-competitive results of finite-horizon models, we find that the possibility of forward trading allows firms to sustain collusive profits that otherwise would not be possible. The result holds both for price and quantity competition and follows because (collusive) contracting of future sales is more effective in deterring deviations from the collusive plan than in inducing the previously identified pro-competitive effects.

Liquidity risks on power exchanges

Financial derivatives are important hedging tool for asset’s manager. Electricity is by its very nature the most volatile commodity, which creates big incentive to share the risk among the market participants through financial contracts. But, even if volume of derivatives contracts traded on Power Exchanges has been growing since the beginning of the restructuring of the sector, electricity markets continue to be considerably less liquid than other commodities. This paper tries to quantify the effect of this insufficient liquidity on power exchange, by introducing a pricing equilibrium model for power derivatives where agents can not hedge up to their desired level. Mathematically, the problem is a two stage stochastic Generalized Nash Equilibrium and its solution is not unique. Computing a large panel of solutions, we show how the risk premium and player’s profit are affected by the illiquidity.illiquidity, electricity, power exchange, artitrage, generalized Nash Equilibrium, equilibrium based model, coherent risk valuation

Innovative Revenue Management Practices with Probabilistic Elements

Sale of products with a probabilistic nature, where customers do not know which product they will receive at the time of service, has become popular over the recent years. In the revenue management literature, there has been a growing interest in understanding these modern approaches using analytical techniques. On the other hand, customer-centric revenue management has been replacing the long-standing inventory-centric approach because of the availability of rich data sets by focusing on understanding and predicting customer behavior and then optimizing price and/or quantity related decisions. In this dissertation, we take a customer-centric approach and do not only provide analytical results, but also empirically investigate how customers make their decisions, which is crucial in order to implement appropriate strategies. We first focus on an innovative hotel revenue management practice called standby upgrades, i.e., a practice where the guest is only charged for the discounted upgrade if it is available at the time of arrival. In particular, Chapter 2 discusses how to optimally price standby upgrades and evaluates their benefits through an analytical model. Chapter 3 uses a major hotel chain’s booking and standby upgrades data to investigate the extent of strategic guest behavior through empirical analysis. Then, we focus on another innovative revenue management practice, but in the mega event industry, called team-specific ticket options. Chapter 4 studies fans’ decision-making process for the 2015 College Football season using a unique data set