Handbook of Multi-Commodity Markets and Products: Structuring, Trading and Risk Management

CHAPTER 6 Weather Risk and Weather Derivatives

Alessandro Mauro

6.1 INTRODUCTION

Under the traditional view of neoclassical economics, the producible quantity of goods and services is considered to be known once we know the levels of inputs and their productivity. This assumption allows us to build a supply curve that defines, for any given price, the quantity of the good that the individual producer, and the aggregate production system, will be able to offer on the market. On the contrary, the demand curve is a mathematical function and therefore deterministic, which expresses the quantity demanded at any price, based on individual preferences. The market equilibrium will inevitably be reached at the intersection of the supply curve with the demand curve, the juncture where you determine the quantity traded and the market price. The price system then takes the role of market equilibrium setting in an economy described as neoclassical.

Economic theory has subsequently recognized the possibility of fluctuations in the price level, especially in markets where transactions occur frequently or where goods are even continuously exchanged. Models have been developed attempting to explain and predict the level of these prices, from which general modern risk management has evolved. Markets and financial instruments were created with the aim of reducing or amplifying the exposure of agents to the fluctuation of these prices. However, the economic discipline and risk management continued ...