Hedging Climate Risks with Derivatives

25 Pages Posted: 5 Apr 2010 Last revised: 11 May 2010

See all articles by Daniel Alexandre Bloch

Daniel Alexandre Bloch

Université Paris VI Pierre et Marie Curie

James Annan

Frontier Research Center for Global Change (FRCGC)

Justin Bowles

affiliation not provided to SSRN

Date Written: May 10, 2010

Abstract

With short-term and seasonal variations filtered out, the data for the climate is closer to stationary, predictable for some time in the future and can be approximated with a Markov process, thus demonstrating that climate and weather time series exhibit diffeing characteristics. Hence, based on statistical analysis of the temperature time series, we consider an Ornstein-Uhlenbeck process for the dynamics of the global mean temperature and use semi-empirical models for estimating the global sea-level response. We then use the concept of absence of arbitrage opportunities and define a simple pricing rule with stochastic interest rates for evaluating climate derivatives. Finally, we discuss three financial products that enable different parties who feel vulnerable to climate change to hedge their risks or shoulder additional risks where a cost-benefit advantage exists, and we describe their pricing formula. We first consider a digital coupon swap allowing two parties to bet on sea-level rise at different fixing time and then introduce a climate default swap providing a party with protection against a rise in the sea-level where the default is the first passage time of an up barrier. As a special case, we look at the pricing of a climate default bond or nature-linked bond.

Keywords: Climate Derivatives, Climate Risks, Semi-Empirical Sea-Level Model, Climate Default Swap

Suggested Citation

Bloch, Daniel Alexandre and Annan, James and Bowles, Justin, Hedging Climate Risks with Derivatives (May 10, 2010). Available at SSRN: https://ssrn.com/abstract=1583354 or http://dx.doi.org/10.2139/ssrn.1583354

Daniel Alexandre Bloch (Contact Author)

Université Paris VI Pierre et Marie Curie ( email )

175 Rue du Chevaleret
Paris, 75013
France

James Annan

Frontier Research Center for Global Change (FRCGC) ( email )

United States

Justin Bowles

affiliation not provided to SSRN ( email )

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