Weather derivatives to mitigate meteorological risks in tourism management: An empirical application to celebrations of Comunidad Valenciana (Spain)

Abstract

This article explores the possibility of implementing weather derivatives in cultural events through an empirical application to celebrations of Comunidad Valenciana (Spain). Temperature- and rainfall-based options geared to the three counties of this Autonomous Community are proposed to mitigate the risk exposure of this event. First, the contracts are priced through the Index Value Simulation and Daily Simulation techniques, which rely on Monte Carlo simulations. Next, they are used to design realistic hedging strategies, which are evaluated under different meteorological scenarios. The degree of geographical basis risk affecting this region, as measured by the root mean square error, is also assessed since it is a common issue refraining the application of weather derivatives. The outcomes attained emphasize the high hedging potential of the suggested tools and indicate the appropriateness of considering, on a case-by-case basis, the possibility of using a combination of derivatives geared to nearby stations as a solution to mitigate basis risk exposure.