Hedging global environment risks: An option based portfolio insurance

This paper introduces a financial hedging model for global environmental risks. Our approach is based on portfolio insurance under hedging constraints. Each investor is assumed to maximize the expected utility of his/her portfolio which includes financial and environmental assets. The optimal investment is determined for quite general utility functions and hedging constraints. Our results show how and why derivative assets should be introduced in the portfolio to hedge environmental risks. The main conclusion of the paper is that new types of options which combine both equity and environmental assets should be used, contrary to the current practice which considers two separate option markets.