In the previous chapter we discussed the methods that can be used to model the pay-offs of a portfolio of weather derivatives, taking into account the distributions of each weather index and the correlations between the indices. We now turn to the question of how portfolios can be managed. We start with a discussion of some of the different ways for measuring the performance of a portfolio. These methods are then applied to the question of how to expand a portfolio (which contracts to add) and how to price contracts against a portfolio. We then discuss various methods for understanding portfolios, and look at the hedging of portfolios using swap contracts.

Risk and return

Having modelled a portfolio using either an index-based method, a daily-simulation-based method or the general method of section 7.8 that mixes the two, there are a lot of questions we can ask to understand better what is creating the total risk and return profile in the portfolio. However, before describing these questions, and how to answer them, we need to look in more detail at how actually to measure risk and return.

Defining return

The word ‘return’ itself is used in a number of different ways in finance. First, we can look back at the performance of an investment that has now run its course. We might calculate the absolute return, which is simply the profit, in monetary units, that the investment yielded.