Optimum Hurricane Futures Hedge in a Warming Environment: A Risk-Return Jump-Diffusion Approach

We develop an optimum risk–return hurricane hedge model in a doubly stochastic jump-diffusion economy. The model's concave risk–return trade-off dictates that a higher correlation between hurricane power and insurer's loss, a smaller variable hedging cost, and a larger market risk premium...

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Bibliographic Details
Published in:The Journal of risk and insurance 2014-03, Vol.81 (1), p.199-217
Main Authors: Chang, Carolyn W., Chang, Jack S. K., Wen, Min-Ming
Format: Article
Language:English
Subjects:
Analysis
Casualty losses
Climate models
Climatic changes
Cost efficiency
Economic aspects
Environmental aspects
Financial risk
Futures
Futures trading
Global warming
Hedging
Hedging (Finance)
Hurricanes
Insurance industry
Investment risk
Marginal costs
Risk premiums
Variable costs
Weather
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Summary:We develop an optimum risk–return hurricane hedge model in a doubly stochastic jump-diffusion economy. The model's concave risk–return trade-off dictates that a higher correlation between hurricane power and insurer's loss, a smaller variable hedging cost, and a larger market risk premium result in a less costly but more effective hedge. The resulting hedge ratio comprises of a positive diffusion, a positive jump, and a negative hedging cost component. Numerical results show that hedging hurricane jump risks is most crucial with jump volatility being the dominant factor, and the faster the warming the more pronounced the jump effects.
ISSN:0022-4367
1539-6975
DOI:10.1111/j.1539-6975.2012.01492.x