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Climate risks and weather derivatives: A copula-based pricing model

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  • Bressan, Giacomo Maria
  • Romagnoli, Silvia

Abstract

The paper focuses on the role of climate and weather derivatives (CDs/WDs for short) as instruments to hedge climate risk. The aim of this paper is twofold: (i) we introduce a copula-based pricing methodology for multivariate CDs/WDs, whose flexible theoretical framework allows to be suited to any pricing application and possible structure of multivariate products, and (ii) we discuss the impact of CDs/WDs on climate risk and their implication for financial stability. Using the proposed framework, we illustrate a calibration example on a case study on Italian data. We find that Archimedean copula functions characterized by left tail dependence are generally more suitable to fit the data, depending on the season and the location. We also explore the advantages of using more sophisticated, i.e. multivariate, functions and assess the improvement of fitting. Subsequently, leveraging both the theoretical model and the empirical results, we discuss the relation between climate risk hedging and financial stability. Especially, we move from modeling complexities and limitations to illustrate how incorrect calculations (i.e. mispricings, or over/under estimations of capital at risk) can, alongside with climate change effect, increase rather than reduce the climate physical risk and hence the concerns for financial stability. Finally, we discuss this point in relation with the legislative framework, noting how, in the current context of uncertain legislation and imperfect pricing, climate hedging risks are likely to do more harm than good.

Suggested Citation

  • Bressan, Giacomo Maria & Romagnoli, Silvia, 2021. "Climate risks and weather derivatives: A copula-based pricing model," Journal of Financial Stability, Elsevier, vol. 54(C).
    • Handle: RePEc:eee:finsta:v:54:y:2021:i:c:s1572308921000371
    DOI: 10.1016/j.jfs.2021.100877
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    References listed on IDEAS

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    Cited by:

    1. Yan, Meilan & Li, Youwei & Pantelous, Athanasios A. & Vigne, Samuel A. & Zhang, Dalu, 2024. "A comparative and conceptual intellectual study of environmental topic in economic and finance," International Review of Financial Analysis, Elsevier, vol. 91(C).
    2. Vilija Aleknevičien&# & Asta Bendoraityt&#, 2023. "Role of Green Finance in Greening the Economy: Conceptual Approach," Central European Business Review, Prague University of Economics and Business, vol. 2023(2), pages 105-130.
    3. Shanghui Jia & Xinhui Chen & Liyan Han & Jiayu Jin, 2023. "Global climate change and commodity markets: A hedging perspective," Journal of Futures Markets, John Wiley & Sons, Ltd., vol. 43(10), pages 1393-1422, October.
    4. Carè, R. & Weber, O., 2023. "How much finance is in climate finance? A bibliometric review, critiques, and future research directions," Research in International Business and Finance, Elsevier, vol. 64(C).
    5. Giovanni Masala & Marco Micocci & Andrea Rizk, 2022. "Hedging Wind Power Risk Exposure through Weather Derivatives," Energies, MDPI, vol. 15(4), pages 1-30, February.
    6. Chabot, Miia & Bertrand, Jean-Louis, 2023. "Climate risks and financial stability: Evidence from the European financial system," Journal of Financial Stability, Elsevier, vol. 69(C).

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    More about this item

    Keywords

    Weather derivatives; Climate risk; Climate finance; Climate change; Financial stability; Copula functions;
    All these keywords.

    JEL classification:

    • Q54 - Agricultural and Natural Resource Economics; Environmental and Ecological Economics - - Environmental Economics - - - Climate; Natural Disasters and their Management; Global Warming
    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing
    • D46 - Microeconomics - - Market Structure, Pricing, and Design - - - Value Theory
    • C31 - Mathematical and Quantitative Methods - - Multiple or Simultaneous Equation Models; Multiple Variables - - - Cross-Sectional Models; Spatial Models; Treatment Effect Models; Quantile Regressions; Social Interaction Models
    • C32 - Mathematical and Quantitative Methods - - Multiple or Simultaneous Equation Models; Multiple Variables - - - Time-Series Models; Dynamic Quantile Regressions; Dynamic Treatment Effect Models; Diffusion Processes; State Space Models

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