Journal of Energy Markets

Risk.net

Managing adverse temperature conditions through hybrid financial instruments

Silvana Stefani, Enrico Moretto, Matteo Parravicini, Simone Cambiaghi, Adeyemi Sonubi, Gleda Kutrolli and Vanda Tulli

  • This article shows how to hedge meteorological risk;
  • This paper investigates the pricing of a weather derivative that results being effective in a well-defined geographical area;
  • The main result is the determination of the value of a temperature-based forward option contract.

Recent international policy initiatives focus on reducing carbon emissions to limit warming. It is almost universally recognized that risks connected to climatic changes are unpredictable in their consequences. Moreover, attempts (for instance, the 2016 Paris conference) to manage climatic changes at a global level have been counter-balanced by ambiguous US policy. Surprisingly, the financial world does not seem to care much about this problem. Yet, it is estimated that 80% of world industries (ie, agriculture, construction sector and hospitality activities) are affected (totally or in part) by climate. Rain or low temperatures disrupt tourism; heavy rain or high temperatures devastate crops and damage farmers. This work contributes to existing literature by proposing temperature-based risk management using hybrid financial instruments built on weather derivatives. Based on well-established literature, we first model temperature time series; we then price one-month forward option contracts for hedging adverse outcomes. Our results exploit the daily temperature data set (1951–2016) collected in Arezzo, Italy. We then show how a “negative” weather performance can be counterbalanced by the “positive” performance of a hedging over-the-counter financial instrument, which can be tailored to meet specific needs.

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