A Novel Financial Market for Mitigating Hurricane Risk. Part I: Market Structure and Model Results

Abstract

novel financial market for hedging the effects of landfalling hurricanes is described and illustrated. The structure of the market is one sided and parimutuel, so that participants buy contracts pertaining to hurricane landfall locations from an exchange rather than from other market participants, and settlements for contracts associated with the landfall location are funded by purchases in all other outcomes. Contract prices are updated automatically and objectively using a recently developed adaptive control algorithm that responds to inferred aggregate probability assessments of the market participants. The market is intended to supplement insurance by providing a mechanism to shift risk for costs not covered under existing windstorm insurance. Operation of the market mechanism is illustrated in an idealized setting and in a spatially explicit historical simulation for Hurricane Charley (2004). A companion paper in this issue describes empirical validation of this market mechanism in an experimental market setting.