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The pricing of temperature futures at the Chicago Mercantile Exchange

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  • Dorfleitner, Gregor
  • Wimmer, Maximilian
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    Abstract

    This paper analyzes observed prices of US temperature futures at the Chicago Mercantile Exchange (CME). Results show that an index modeling approach without detrending captures the prices exceptionally well. Moreover, weather forecasts significantly influence prices up to 11 days ahead. It is shown that valuations of temperature futures relying on a model without detrending yield biased valuations by overpricing winter contracts and underpricing summer contracts. Several trading strategies are devised to exploit the mispricing observed at the CME and to demonstrate that speculating on temperature futures can not only generate high overall returns, but also perform well on a risk-adjusted basis.

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    File URL: http://www.sciencedirect.com/science/article/B6VCY-4XX15SS-1/2/44028f3fca9fc6d375cf17044256f145
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    Bibliographic Info

    Article provided by Elsevier in its journal Journal of Banking & Finance.

    Volume (Year): 34 (2010)
    Issue (Month): 6 (June)
    Pages: 1360-1370

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    Handle: RePEc:eee:jbfina:v:34:y:2010:i:6:p:1360-1370

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    Web page: http://www.elsevier.com/locate/jbf

    Related research

    Keywords: Weather derivatives Index modeling Weather forecast Futures pricing Trading strategy;

    References

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    1. FRED ESPEN BENTH & JŪRATĖ SALTYTĖ BENTH & STEEN KOEKEBAKKER, 2007. "Putting a Price on Temperature," Scandinavian Journal of Statistics, Danish Society for Theoretical Statistics & Finnish Statistical Society & Norwegian Statistical Association & Swedish Statistical Association, vol. 34(4), pages 746-767.
    2. Dorje Brody & Joanna Syroka & Mihail Zervos, 2002. "Dynamical pricing of weather derivatives," Quantitative Finance, Taylor & Francis Journals, vol. 2(3), pages 189-198.
    3. Peter Alaton & Boualem Djehiche & David Stillberger, 2002. "On modelling and pricing weather derivatives," Applied Mathematical Finance, Taylor & Francis Journals, vol. 9(1), pages 1-20.
    4. Jacobsen, Ben & Marquering, Wessel, 2009. "Is it the weather? Response," Journal of Banking & Finance, Elsevier, vol. 33(3), pages 583-587, March.
    5. A. Zapranis & A. Alexandridis, 2008. "Modelling the Temperature Time-dependent Speed of Mean Reversion in the Context of Weather Derivatives Pricing," Applied Mathematical Finance, Taylor & Francis Journals, vol. 15(4), pages 355-386.
    6. Chang, Shao-Chi & Chen, Sheng-Syan & Chou, Robin K. & Lin, Yueh-Hsiang, 2008. "Weather and intraday patterns in stock returns and trading activity," Journal of Banking & Finance, Elsevier, vol. 32(9), pages 1754-1766, September.
    7. Jacobsen, Ben & Marquering, Wessel, 2008. "Is it the weather?," Journal of Banking & Finance, Elsevier, vol. 32(4), pages 526-540, April.
    8. M. Davis, 2001. "Pricing weather derivatives by marginal value," Quantitative Finance, Taylor & Francis Journals, vol. 1(3), pages 305-308.
    9. Wolfgang Härdle & Brenda López Cabrera, 2009. "Implied Market Price of Weather Risk," SFB 649 Discussion Papers SFB649DP2009-001, Sonderforschungsbereich 649, Humboldt University, Berlin, Germany.
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    11. Lucas, Robert E, Jr, 1978. "Asset Prices in an Exchange Economy," Econometrica, Econometric Society, vol. 46(6), pages 1429-45, November.
    12. Campbell, Sean D. & Diebold, Francis X., 2004. "Weather forecasting for weather derivatives," CFS Working Paper Series 2004/10, Center for Financial Studies (CFS).
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    14. Oliver Ledoit & Michael Wolf, 2008. "Robust Performance Hypothesis Testing with the Sharpe Ratio," IEW - Working Papers 320, Institute for Empirical Research in Economics - University of Zurich.
    15. Fred ESPEN Benth & Jurate saltyte Benth, 2007. "The volatility of temperature and pricing of weather derivatives," Quantitative Finance, Taylor & Francis Journals, vol. 7(5), pages 553-561.
    16. Kamstra, Mark J. & Kramer, Lisa A. & Levi, Maurice D., 2009. "Is it the weather? Comment," Journal of Banking & Finance, Elsevier, vol. 33(3), pages 578-582, March.
    17. Fred Espen Benth & Jurate Saltyte-Benth, 2005. "Stochastic Modelling of Temperature Variations with a View Towards Weather Derivatives," Applied Mathematical Finance, Taylor & Francis Journals, vol. 12(1), pages 53-85.
    18. Jobson, J D & Korkie, Bob M, 1981. "Performance Hypothesis Testing with the Sharpe and Treynor Measures," Journal of Finance, American Finance Association, vol. 36(4), pages 889-908, September.
    19. Pirrong, Craig & Jermakyan, Martin, 2008. "The price of power: The valuation of power and weather derivatives," Journal of Banking & Finance, Elsevier, vol. 32(12), pages 2520-2529, December.
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    Citations

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    Cited by:
    1. Wolfgang Karl Härdle & Brenda López-Cabrera & Matthias Ritter, 2012. "Forecast based Pricing of Weather Derivatives," SFB 649 Discussion Papers SFB649DP2012-027, Sonderforschungsbereich 649, Humboldt University, Berlin, Germany.
    2. Füss, Roland & Mahringer, Steffen & Prokopczuk, Marcel, 2013. "Electricity Derivatives Pricing with Forward-Looking Information," Working Papers on Finance 1317, University of St. Gallen, School of Finance.
    3. Goulas, Lambros & Skiadopoulos, George, 2012. "Are freight futures markets efficient? Evidence from IMAREX," International Journal of Forecasting, Elsevier, vol. 28(3), pages 644-659.
    4. Matthias Ritter, 2012. "Can the market forecast the weather better than meteorologists?," SFB 649 Discussion Papers SFB649DP2012-067, Sonderforschungsbereich 649, Humboldt University, Berlin, Germany.
    5. 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.
    6. A. Alexandridis & A. Zapranis, 2013. "Wind Derivatives: Modeling and Pricing," Computational Economics, Society for Computational Economics, vol. 41(3), pages 299-326, March.
    7. Andreas Groll & Brenda López-Cabrera & Thilo Meyer-Brandis, 2014. "A consistent two-factor model for pricing temperature derivatives," SFB 649 Discussion Papers SFB649DP2014-006, Sonderforschungsbereich 649, Humboldt University, Berlin, Germany.
    8. 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.
    9. Auer, Benjamin R. & Schuhmacher, Frank, 2013. "Performance hypothesis testing with the Sharpe ratio: The case of hedge funds," Finance Research Letters, Elsevier, vol. 10(4), pages 196-208.

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