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Dynamical pricing of weather derivatives

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  • Dorje Brody
  • Joanna Syroka
  • Mihail Zervos
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    Abstract

    The dynamics of temperature can be modelled by means of a stochastic process known as fractional Brownian motion. Based on this empirical observation, we characterize temperature dynamics by a fractional Ornstein-Uhlenbeck process. This model is used to price two types of contingent claims: one based on heating and cooling degree days, and one based on cumulative temperature. We derive analytic expressions for the expected discounted payoffs of such derivatives, and discuss the dependence of the results on the fractionality of the temperature dynamics.

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    Bibliographic Info

    Article provided by Taylor & Francis Journals in its journal Quantitative Finance.

    Volume (Year): 2 (2002)
    Issue (Month): 3 ()
    Pages: 189-198

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    Handle: RePEc:taf:quantf:v:2:y:2002:i:3:p:189-198

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    Cited by:
    1. Neuenkirch, Andreas, 2008. "Optimal pointwise approximation of stochastic differential equations driven by fractional Brownian motion," Stochastic Processes and their Applications, Elsevier, vol. 118(12), pages 2294-2333, December.
    2. Markus Stowasser, 2011. "Modelling rain risk: a multi-order Markov chain model approach," Journal of Risk Finance, Emerald Group Publishing, vol. 13(1), pages 45-60, January.
    3. 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.
    4. 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.
    5. Svec, J. & Stevenson, M., 2007. "Modelling and forecasting temperature based weather derivatives," Global Finance Journal, Elsevier, vol. 18(2), pages 185-204.
    6. Ahmet Göncü, 2011. "Pricing temperature-based weather derivatives in China," Journal of Risk Finance, Emerald Group Publishing, vol. 13(1), pages 32-44, January.
    7. Ahčan, Aleš, 2012. "Statistical analysis of model risk concerning temperature residuals and its impact on pricing weather derivatives," Insurance: Mathematics and Economics, Elsevier, vol. 50(1), pages 131-138.
    8. A. Alexandridis & A. Zapranis, 2013. "Wind Derivatives: Modeling and Pricing," Computational Economics, Society for Computational Economics, vol. 41(3), pages 299-326, March.
    9. Baojing Sun & Changhao Guo & G. Cornelis van Kooten, 2013. "Weather Derivatives and Crop Insurance in China," Working Papers 2013-02, University of Victoria, Department of Economics, Resource Economics and Policy Analysis Research Group.
    10. Christos Floros, 2011. "On the relationship between weather and stock market returns," Studies in Economics and Finance, Emerald Group Publishing, vol. 28(1), pages 5-13, March.
    11. Høg, Espen P. & Frederiksen, Per H., 2006. "The Fractional Ornstein-Uhlenbeck Process: Term Structure Theory and Application," Finance Research Group Working Papers F-2006-01, University of Aarhus, Aarhus School of Business, Department of Business Studies.
    12. Berg, Ernst & Schmitz, Bernhard & Starp, Michael, 2006. "Weather derivatives as an instrument to hedge against the risk of high energy cost in greenhouse production," 2006 Annual meeting, July 23-26, Long Beach, CA 21378, American Agricultural Economics Association (New Name 2008: Agricultural and Applied Economics Association).
    13. Taylor, James W. & Buizza, Roberto, 2006. "Density forecasting for weather derivative pricing," International Journal of Forecasting, Elsevier, vol. 22(1), pages 29-42.
    14. Barndorff-Nielsen, Ole E. & Benth, Fred Espen & Pedersen, Jan & Veraart, Almut E.D., 2014. "On stochastic integration for volatility modulated Lévy-driven Volterra processes," Stochastic Processes and their Applications, Elsevier, vol. 124(1), pages 812-847.
    15. 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.

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