Optimal risk management considering environmental and climatic changes

Abstract Climate change presents challenges to policy and economic stability, necessitating effective trading strategies to reduce environmental risks. This article addresses gaps in existing studies by using a Markov‐switching model to consider climate risk. Backward stochastic differential equations are used to optimize utility with three hedging strategies based on the concept of risk aversion. Numerical scenarios confirm the model's superiority in incorporating exogenous events, with our risk‐averse strategy outperforming classical approaches. Our strategy outperforms classical strategies by taking a flexible risk trading when investors face risk‐averse behavior due to climate risk events. The findings presented in this article have important implications for the development of more resilient investment portfolios and can contribute to climate policy.