Four Methods for the Static Hedging of Weather Derivative Portfolios

Abstract

We address the question of how to statically hedge weather derivative portfolios with weather swap contracts. In particular we consider four different risk measures that one might choose to minimise, and compare the sizes of swap contract needed to minimise the risk in a portfolio consisting of a single option. We find that for at the money options the size of hedge needed to minimise the four risk measures is the same, while for out of the money options the sizes of the hedges are different. Traditional variance based hedging leads to the smallest hedge of the four methods considered.

Keywords: Weather derivatives, hedging, standard deviation, semi-standard deviation, value at risk, expected shortfall

JEL Classification: G13