TABLE OF CONTENTS Chapter I. Introduction 1 1.1 Background 2 1.2 Literature on Risk and Risk Management 7 1.3 The Frontier of Risk Management 11 1.4 Weather Risk and Weather Derivatives 13 Chapter II. Weather Derivative and Its Valuation 17 2.1 Introduction 17 2.2 Basic Model 28 2.3 Valuation of Weather Derivative 38 Chapter III. Weather Derivative and Commodity Forward 48 3.1 Scenario sets 49 3.2 Optimal Hedging 58 Chapter IV. Basis Risk and Its Implications 86 4.1 Introduction 86 4.2 Implications of Basis Risk 89 Appendix I. Figures 106 Appendix II. Extensions of Principle of Increasing Uncertainty 125 Reference 135 Vita 142 ============================ This dissertation addresses how the weather derivative hedges the corporate risk, how to price the indexed derivative as an exotic derivative instrument, and the implications of basis risk embedded in the weather derivative. The traditional one-dimension financial market framework is expanded to include the weather index. Under this expanded framework, the stock market values of the unhedged and hedged firms are studied first. This provides the base to investigate the pricing formula for weather derivative under the expanded framework. It is found that both financial and actuarial approaches are integrated to price the weather derivative. A positive risk management paradigm must provide the criteria to choose the optimal hedging instrument(s) for separable risks. This dissertation provides the criteria to choose optimal hedging contract set to hedge the weather risk, under different corporate leverage levels. It has been found that weather derivative outperforms the traditional commodity forward in most of the scenarios. When corporate leverage levels increase, the positive role of the weather derivative or the commodity forward diminishes. Basis risk arises by introducing the standard weather index, and providing the industry-standard payment when the weather derivative is exercised. The implication of basis risk is investigated under the same expanded framework. It is found that in most of the scenarios, basis risk is innocuous.