Thursday, 13 January 2000: 2:00 PM
The buying and selling of weather derivatives leaves both parties susceptible to risk. The purchaser of the derivative will have premium risk but will be reducing their business-related exposure. However, the seller of the derivative will have risk up to the limit of the option. In order to reduce this risk or "hedge", the seller has several options. The seller can "back-to-back" the derivative. This would require purchasing the identical structure from another party. This is beneficial only if the second derivative can be bought for less than the premium collected on the original sale. Another hedging technique would be for the seller of the original derivative to purchase a similar structure for another location that has a strong correlation of the underlying "commodity" with the original location. Specifically, if a winter HDD call option for Baltimore, MD is sold; the seller of the option can buy a winter HDD call option for Washington, DC. Similarly, if a location is strongly anti-correlated, a derivative can be structured to hedge the original sale. The proper structuring of a transaction would allow the original seller of the option to retain some of the initial premium and reduce their weather derivative exposure.
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