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Putting a Price on Temperature

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Author Info

  • FRED ESPEN BENTH
  • JŪRATĖ SALTYTĖ BENTH
  • STEEN KOEKEBAKKER

Abstract

This paper analyzes the weather derivatives traded at the Chicago Mercantile Exchange (CME), with futures and options written on different temperature indices. We propose to model the temperature dynamics as a continuous-time autoregressive process with lag "p" and seasonal variation. The choice ""p"=3" turns out to be sufficient to explain the temperature dynamics observed in Stockholm, Sweden, where we fit the model to more than 40 years of daily observations. The main finding is a clear seasonal variation in the regression residuals, where temperature shows high variability in winter, low in autumn and spring, and increasing variability towards the early summer. Our model allows for derivations of explicit prices for several futures and options. Note that the volatility term structure of futures written on the cumulative average temperature has a "modified" Samuelson effect, where the volatility prior to the measurement period increases, except for the last part, where it may decrease. Copyright 2007 Board of the Foundation of the Scandinavian Journal of Statistics..

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Bibliographic Info

Article provided by Danish Society for Theoretical Statistics & Finnish Statistical Society & Norwegian Statistical Association & Swedish Statistical Association in its journal Scandinavian Journal of Statistics.

Volume (Year): 34 (2007)
Issue (Month): 4 ()
Pages: 746-767

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Handle: RePEc:bla:scjsta:v:34:y:2007:i:4:p:746-767

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Web page: http://www.blackwellpublishing.com/journal.asp?ref=0303-6898

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Cited by:
  1. Šaltytė Benth, Jūratė & Benth, Fred Espen, 2012. "A critical view on temperature modelling for application in weather derivatives markets," Energy Economics, Elsevier, vol. 34(2), pages 592-602.
  2. Elias, R.S. & Wahab, M.I.M. & Fang, L., 2014. "A comparison of regime-switching temperature modeling approaches for applications in weather derivatives," European Journal of Operational Research, Elsevier, vol. 232(3), pages 549-560.
  3. Benth, Fred Espen & Taib, Che Mohd Imran Che, 2013. "On the speed towards the mean for continuous time autoregressive moving average processes with applications to energy markets," Energy Economics, Elsevier, vol. 40(C), pages 259-268.
  4. Dorfleitner, Gregor & Wimmer, Maximilian, 2010. "The pricing of temperature futures at the Chicago Mercantile Exchange," Journal of Banking & Finance, Elsevier, vol. 34(6), pages 1360-1370, June.
  5. Benth, Fred Espen & Saltyte Benth, Jurate, 2009. "Dynamic pricing of wind futures," Energy Economics, Elsevier, vol. 31(1), pages 16-24, January.
  6. López Cabrera, Brenda & Odening, Martin & Ritter, Matthias, 2013. "Pricing rainfall futures at the CME," Journal of Banking & Finance, Elsevier, vol. 37(11), pages 4286-4298.

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