Weather derivatives : corporate hedging and valuation



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Weather derivatives constitute a rather recent kind of financial products developed to hedge weather risks. The development of weather derivatives represents one of the recent trends toward the convergence of insurance and finance. This dissertation addresses the valuation issue of weather derivatives in the incomplete market, hedging effectiveness of standardized weather derivatives, as well as weather hedging with the consideration of basis risk and credit risk. Basis risk is an important concern in hedging with standardized contracts. In Chapter 2, we analyze the basis risk of Heating Degree Days (HDD)/Cooling Degree Days (CDD)-indexed weather derivatives in the U.S. electricity market. Two types of standardized weather indices are used. Hedging effectiveness is compared between seasons, between different underlying indices, and among the months. Our findings extend the extant literature on weather hedging and provide important implications to all parties engaged in the weather-derivative market. Credit risk has attracted much attention in the weather risk market since the bankruptcy of Enron. In Chapter 3, we analyze risk-sharing efficiency effects of basis hedging, the joint use of the standardized exchange-traded weather derivatives, and some weather derivatives (basis weather derivatives) for hedging the basis risk, by considering the credit risk of OTC contracts. Simulations are conducted to illustrate the determinants of the hedging ratios and hedging effectiveness. Empirical analyses of the basis hedging effectiveness for some U. S. cities are provided. Weather derivatives are a classic, incomplete market model. Actuarial and complete financial valuation models are not appropriate to price weather derivatives. In Chapter 4, we propose and implement an indifference-valuation approach to price weather derivatives in the incomplete market. The fundamental idea for this approach stems from the basic economic principle of certainty equivalent, but is modified and extended to accommodate partial hedging in the financial market. In the mean-variance framework, we adopt the indifference approach to price a single weather derivative on its stand-alone performance, as well as to price the weather derivatives in the context of the marginal changes they cause to the weather derivatives portfolio.