financial risk, in that the ultimate outcome of the trade is uncertain. The risk
from owning a portfolio of weather derivatives comes from the uncertainty
associated with all the possible outcomes for the payouts of the contracts in
that portfolio.
From the point of view of risk measurement, weather derivatives have
similarities to both insurance contracts and financial derivatives. The risk
of a portfolio of insurance contracts is typically measured in terms of the
amounts of money, at various levels of probability, that the insurer may
have to pay out to policy holders over the course of a year. In contrast, the
risk of a portfolio of financial derivatives is typically measured in terms
of how the liquidation value of the portfolio might reduce over a short
time period, of maybe a day or a week. The rationale for this approach is
that if the estimated risk is too large then one can consider actually liquidating
the portfolio. The difference between the measurement of risk for
insurance contracts and financial derivatives arises because insurance contracts
cannot typically be liquidated or hedged, while financial derivatives
can be.
Which of these two approaches is most appropriate for weather derivatives?
In spite of the name, the insurance framework is the best starting
point for understanding weather derivative risk. This is because the weather
derivatives market is still rather small, and most weather derivatives cannot
be liquidated or hedged in any practical way. The owner of the derivative
usually has to face the possibility that they may have to hold the
contract to expiry, and so the outcome at expiry is very important. The
exception to this is that some contracts, particularly monthly and seasonal
contracts based on temperature at locations such as London, Chicago and
New York, are more heavily traded, and for these contracts it may be possible
to liquidate or hedge positions. For these contracts, it may therefore
be reasonable to start thinking about risk over short time-horizons, as with
other financial derivatives. For most of this chapter, however, we will deal
with the insurance definition of risk, which we will call “expiry risk”, since
it considers the outcome of contracts at expiry. Then in section 8.12 we
briefly come back to the question of how to estimate risk over shorter time
horizons.
Read More: Defining Risk For Weather Derivative Portofolios
