Applications of Weather Derivatives in the Energy Market

Abstract

This paper analyzes various types of weather-related risks in different industries. Due to the existence and popularity of the established weather insurance market, we also discuss the differences between weather derivatives and insurance, and the advantages of using weather derivatives instead of insurance in weather risk management. First, we discuss the applications of temperature futures by providing a static, simple strategy to hedge volume risks in practice. Then, by building up a system of models for energy and temperature, we propose a dynamic hedging strategy in order to hedge energy futures using temperature futures.

Keywords: weather derivatives, mean-reverting process, energy markets, dynamic hedging, crude oil futures