This chapter discusses various aspects of risk management for companies that deal with weather derivatives. The simplest aspect of risk management is estimating the value of currently held positions. This is known as either marking to model or marking to market, depending on how ‘value’ is defined. Mark to model involves calculating expected pay-offs while mark to market looks at the current market value of the contracts held. Having evaluated current positions it is often desirable to understand the risk that these positions could pay out less than the expected pay-offs, or that the expected pay-off could deteriorate with time. We will call these two risks ‘expiry risk’ and ‘actuarial value at risk’ respectively. It can also be useful to understand how much we could lose if we are forced to liquidate our positions as soon as possible. We will call this the ‘liquidation value at risk’, which will often be diffierent from the actuarial value at risk. Finally, one may wish to evaluate risk by counterparty (counterparty credit risk) or the risk of a temporary cashflow shortage (liquidity risk).

Before we describe how these values can be estimated for weather portfolios we will look briefly at how similar quantities are estimated for portfolios of more traditional financial products such as equities. Many of the ideas used in the analysis of equities have been adapted for use in the weather market.