Joint optimal ordering and weather hedging decisions: mean-CVaR model

Abstract

This paper considers the problem of hedging inventory risk for a seasonal product whose demand is sensitive to weather conditions, such as the average seasonal temperature. The newsvendor not only decides the order quantity, but also adopts a weather hedging strategy. A typical hedging strategy is to use an option (weather derivative) that is constructed on a weather index before the season begins, which will compensate the buyer of the option if the actual seasonal weather index is above (or below) a given strike level. We adopt the risk measure of Conditional-Value at Risk (\(\hbox{CVaR}\)) and explore the joint decision problem in mean-CVaR criterion. We find that the weather derivative hedging can increase order quantity. Furthermore, it can help the risk-averse newsvendor improve both expected overall and downside profits.