Handling Weather Related Risks Through the Financial Markets: Considerations of Credit Risk, Basis Risk, and Hedging

28 Pages Posted: 24 May 2007

See all articles by Linda L. Golden

Linda L. Golden

University of Texas at Austin - Red McCombs School of Business

Mulong Wang

University of Texas at Austin

Charles C. Yang

Florida Atlantic University

Abstract

The profits of many businesses are strongly affected by weather related events, and insurance against weather related risks (acts of God) has been a traditional domain for transfer of (certain) of these risks. Recent innovations in the capital market have now provided financial instruments to transfer and hedge some of these risks. Unlike insurance solutions, however, using these financial derivative instruments creates a situation in which the return to the purchaser of the instrument is no longer perfectly correlated with the loss experienced. Such a mismatch creates new risks which must be examined and evaluated as part of ascertaining cost effective risk management plans. Two newly engendered risks, basis risk (the risk created by the fact that the return from the financial derivative is a function of weather at a prespecified geographical location which may not be identical to the location of the firm) and credit risk (the risk that the counterparty to the derivative contract may not perform), are analyzed in this article. Using custom tailored derivatives from the over the counter market can decrease basis risk, but increases credit risk. Using standardized exchange traded derivatives decreases credit risk but increases basis risk. Here also the effectiveness of using hedging methods involving forwards and futures having linear payoffs (linear hedging) and methods using derivatives having nonlinear payoffs such as those involving options (nonlinear hedging) for the purpose of hedging basis risk are examined jointly with credit risk.

Suggested Citation

Golden, Linda L. and Wang, Mulong and Yang, Charles C., Handling Weather Related Risks Through the Financial Markets: Considerations of Credit Risk, Basis Risk, and Hedging. Journal of Risk & Insurance, Vol. 74, No. 2, pp. 319-346, June 2007, Available at SSRN: https://ssrn.com/abstract=987401 or http://dx.doi.org/10.1111/j.1539-6975.2007.00215.x

Linda L. Golden (Contact Author)

University of Texas at Austin - Red McCombs School of Business ( email )

Austin, TX 78712
United States

Mulong Wang

University of Texas at Austin ( email )

2317 Speedway
Austin, TX 78712
United States

Charles C. Yang

Florida Atlantic University ( email )

777 Glades Road
Boca Raton, FL 33431
United States

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