Aspects of multivariate analysis and cross-hedging also hold promise for future work. Cross-city
correlations may be crucially important, because they govern the potential for cross-hedging. Hedging
weather risk in a remote Midwestern location might, for example, be prohibitively expensive or even
impossible due to illiquid or nonexistent markets, but if that risk is highly correlated with Chicago’s
weather risk, for which a liquid market exists, effective hedging may still be possible. Hence an obvious
and important extension of the univariate temperature analysis reported in the present paper is multivariate
modeling of daily average temperature in a set of cities, allowing for a time-varying innovation variance-
covariance matrix. Of particular interest would be the fitted and forecasted conditional mean, conditional
variance and conditional covariance dynamics, the covariance matrices of standardized innovations, and the
impulse response functions (which chart the speed and pattern with which weather surprises in one location
are transmitted to other locations).
Another interesting multivariate issue involves weather-related swings in earnings and share prices.
It will be of interest to use the size of weather-related swings in earnings as way to assess the potential for
weather derivatives use. In particular, we need to understand how weather surprises translate into earnings
surprises, which then translate into stock return movements. Some interesting subtleties may arise. As one
example, note that only systematic weather risk should be priced, which raises the issue of how to
disentangle systematic and non-systematic weather risks. As a second example, note that there may be
nonlinearities in the relationship between prices and the weather induced via path dependence; if there is an
early freeze, for example, then it doesn’t matter how good the weather is subsequently: the crop will be
ruined and prices will be high (see Richardson, Bodoukh, Sjen, and Whitelaw, 2001).
References
Black, F. and Scholes, M. (1973), The Pricing of Options and Corporate Liabilities,” Journal of Political
Economy, 81, 637-654.
Bloomfield, P. (1992), “Trends in Global Temperature,” Climate Change, 21, 1-16.
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