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Spatial Risk Premium on Weather Derivatives and Hedging Weather Exposure in Electricity

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  • Wolfgang Karl Hardle and Maria Osipenko

Abstract

Due to the dependency of the energy demand on temperature, weather derivatives enable the effective hedging of temperature related fluctuations. However, temperature varies in space and time and therefore the contingent weather derivatives also vary. The spatial derivative price distribution involves a risk premium. We employ a pricing model for temperature derivatives based on dynamics modeled via a vectorial Ornstein-Uhlenbeck process with seasonal variation. We use an analytical expression for the risk premia depending on variation curves of temperature in the measurement period. The dependence is exploited by a functional principal component analysis of the curves. We compute risk premia on cumulative average temperature futures for locations traded on CME and fit to it a geographically weighted regression on functional principal component scores. It allows us to predict risk premia for nontraded locations and to adopt, on this basis, a hedging strategy, which we illustrate in the example of Leipzig.

Suggested Citation

  • Wolfgang Karl Hardle and Maria Osipenko, 2012. "Spatial Risk Premium on Weather Derivatives and Hedging Weather Exposure in Electricity," The Energy Journal, International Association for Energy Economics, vol. 0(Number 2).
    • Handle: RePEc:aen:journl:33-2-07
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    Cited by:

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    2. Zhuoxin Liu & Laijun Zhao & Chenchen Wang & Yong Yang & Jian Xue & Xin Bo & Deqiang Li & Dengguo Liu, 2019. "An Actuarial Pricing Method for Air Quality Index Options," IJERPH, MDPI, vol. 16(24), pages 1-19, December.
    3. Å tulec, Ivana & Petljak, Kristina & Naletina, Dora, 2019. "Weather impact on retail sales: How can weather derivatives help with adverse weather deviations?," Journal of Retailing and Consumer Services, Elsevier, vol. 49(C), pages 1-10.
    4. Hesamzadeh, Mohammad Reza & Biggar, Darryl R., 2021. "Generalized FTRs for hedging inter-nodal pricing risk," Energy Economics, Elsevier, vol. 94(C).

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