Hedging the Financial Risk of Water Scarcity

Abstract

Water management has evolved beyond a purely engineering challenge, as climate change-induced water shortages significantly impact even the socio-economic systems of the world's wealthiest countries. This chapter introduces two innovative types of weather derivatives designed to hedge against the volumetric risk associated with water scarcity, whether due to light rainfalls or critically low basin levels necessitating public rationing. The first derivative is a European-style Quanto put option, financially settled to mitigate losses from insufficient rainfall. The second is a European digital cash-or-nothing option, tailored to address the depletion of water resources in specific basins. A detailed case study on Trinity Lake in California, USA, demonstrates the effectiveness of these instruments in protecting against the detrimental effects of water shortages.