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Essays on the Weather Derivatives Market.

By Daniel Robert Weagley

Abstract

This dissertation consists of two essays examining the functioning and effects of a recent financial innovation: the weather derivatives market. The modern weather derivatives market originated in the late 1990s and allows participants to share non-catastrophic weather risks. The structure and development of the market provide a relatively clean empirical setting to study and better understand financial markets. The first essay examines how financial sector stress affects asset prices in the weather derivatives market. The structure of the market allows price movements due to financial sector stress to be disentangled from price movements due to fundamentals. Estimated risk premiums, which are small and statistically indistinguishable from zero on average, are 31% per year during the 2008-09 financial crisis. Contracts with greater margin requirements and idiosyncratic risk experience larger increases in risk premiums. Open interest falls by 40%. The results provide evidence that adverse shocks to the capital of financial institutions lead to increased hedging costs for end users and less risk sharing in the economy. The second essay examines how the introduction of weather derivatives affect a government stakeholder: the National Weather Service. More broadly, the essay examines the ability of markets to discipline government agencies. The Chicago Mercantile Exchange has introduced several temperature related derivative contracts on different U.S. cities in a staggered fashion since 1999. The payoffs of these contracts depend on the temperature levels at a specific weather station in the underlying city. We show that the introduction of these contracts improves the accuracy of temperature measurement by the dedicated weather station of the National Weather Services (NWS) in that city. We argue that temperature-based financial markets generate additional scrutiny of the temperature data measured by the NWS, which in turn motivates the agency to minimize measurement errors. Consistent with this idea, stations with higher economic interests in weather derivatives see greater improvement in measurement accuracy. Our results indicate that the visibility and scrutiny generated by financial markets can improve the efficiency of government agencies even in the absence of explicit incentive contracts

Topics: Weather Derivatives
Year: 2014
OAI identifier: oai:deepblue.lib.umich.edu:2027.42/108993

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