Effect of hedging on cash holdings.
Corporations care for liquidity buffers to smooth cash flow shocks in adverse market conditions.
Especially, the cash flows of electric utilities are heavily impacted by seasonal weather conditions: for example, in a
hotter-than-usual summer, electricity demand boosts the earning of electric utilities (e.g., everybody turns on their
air conditioners), whereas in a cooler-than-usual summer, electric utilities may suffer from poor earnings. The
exposure to such weather risk depends on where each electric utility is located: utilities locat ed in stable weather
regions (low weather volatility) may not face much cash flow uncertainty due to weather conditions, whereas those
located in volatile weather regions (high weather volatility) may face great cash flow uncertainty due to weather
conditions.
In 1997, weather derivatives were introduced for firms to hedge such weather risk. That is, firms are able
to buy weather derivative contracts that pay when seasonal weather is milder than usual
