Optimum Hurricane Futures Hedge in a Warming Environment: A Risk–Return Jump‐Diffusion Approach

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AbstractWe develop an optimum risk–return hurricane hedge model in a doubly stochastic jump‐diffusion economy. The model's concave risk–return trade‐off dictates that a higher correlation between hurricane power and insurer's loss, a smaller variable hedging cost, and a larger market risk premium result in a less costly but more effective hedge. The resulting hedge ratio comprises of a positive diffusion, a positive jump, and a negative hedging cost component. Numerical results show that hedging hurricane jump risks is most crucial with jump volatility being the dominant factor, and the faster the warming the more pronounced the jump effects.