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Title: Optimal hedging using both regular and weather derivatives

Authors: Augusto Castillo; Rafael Aguila

Addresses: Escuela de Negocios, Universidad Adolfo Ibáñez, Avenida Diagonal las Torres 2700, oficina 513-C, Santiago, Chile ' Escuela de Administración, Pontificia Universidad Católica de Chile, Avenida Vicuña Mackenna 4860, Santiago, Chile

Abstract: This paper analyses how to achieve optimal hedging of a cash flow to be received at a future date T, when facing price risk, cost and quantity uncertainty. We explore and compare the case where the only instrument available to hedge is a regular forward contract (to hedge the price uncertainty), the case where we only have access to a linear-type weather derivative to hedge quantity, and the case where both types of contracts are available. A closed form solution for both the optimal hedging strategies and the quality of the hedging under each scenario are identified. We show how to obtain the optimal hedging strategies through linear regressions. Then, by using simulations, we explore how the results critically depend on some key factors such as the volatility of some stochastic variables considered and the degree of correlation among some of the variables considered.

Keywords: risk management; hedging; quantity uncertainty; weather derivatives.

DOI: 10.1504/IJBD.2017.083949

International Journal of Bonds and Derivatives, 2017 Vol.3 No.1, pp.1 - 20

Available online: 21 Apr 2017 *

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