Spatial Aggregation and Weather Risk Management

portfolios total risk in the form of systemic weather risk, a substantial portion of which
can be effectively hedged using WDs. These results support the notion that WDs may be
more useful than previously thought, particularly for aggregators of risk such as
re/insurers. In addition, the results show that the use of relatively simple temperature
contracts can achieve reasonable hedging effectiveness.

Conclusion

The study investigates whether WDs are more effective for hedging yield exposures at
large versus small levels of aggregation. This study builds on earlier research in some
important dimensions. We establish a simpler but clearer link between yields and
temperature indexes and highlight how market agents may employ relatively simple WDs
to hedge yield risk. Also, we establish a link between temperatures and yields at a higher
level of aggregation than previous studies. The high performance of the temperature
contracts in hedging systemic risk is related to three factors: the autocorrelations in
month-to-month temperatures (Namias 1986; Jewson and Brix 2005), the highly negative
correlations between temperature and precipitation in extreme events (Namias 1986), and
the non-linear response of yields to temperatures (VB 2004; Dixon et al 1994) which
emerges most noticeably at higher levels of aggregation.

The study provides two contributions. First, a conceptual basis is established for
the notion that WD hedging may be more effective at the reinsurance versus the primary
level, suggesting the potential of WDs for re/insurers. Second, the empirical evidence
substantiates the presence of the aggregation effect which supports the proposition that
WDs, although likely not useful for individual producers, may provide benefits for

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