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Consistent Factor Models For Temperature Markets

Author

Listed:
  • PHILIPP HELL

    (Mathematical Institute, University of Munich, Theresienstrasse 39, 80333 Munich, Germany)

  • THILO MEYER-BRANDIS

    (Mathematical Institute, University of Munich, Theresienstrasse 39, 80333 Munich, Germany)

  • THORSTEN RHEINLÄNDER

    (Department of Statistics, London School of Economics and Political Science, Houghton Street, London WC2A 2AE, UK)

Abstract

We propose an approach for pricing and hedging weather derivatives based on including forward looking information about the temperature available to the market. This is achieved by modeling temperature forecasts by a finite dimensional factor model. Temperature dynamics are then inferred in the short end. In analogy to interest rate theory, we establish conditions which guarantee consistency of a factor model with the martingale dynamics of temperature forecasts. Finally, we consider a specific two-factor model and examine in more detail pricing and hedging of weather derivatives in this context.

Suggested Citation

  • Philipp Hell & Thilo Meyer-Brandis & Thorsten Rheinländer, 2012. "Consistent Factor Models For Temperature Markets," International Journal of Theoretical and Applied Finance (IJTAF), World Scientific Publishing Co. Pte. Ltd., vol. 15(04), pages 1-24.
    • Handle: RePEc:wsi:ijtafx:v:15:y:2012:i:04:n:s0219024912500276
    DOI: 10.1142/S0219024912500276
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    References listed on IDEAS

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    1. Eckhard Platen & Jason West, 2004. "A Fair Pricing Approach to Weather Derivatives," Asia-Pacific Financial Markets, Springer;Japanese Association of Financial Economics and Engineering, vol. 11(1), pages 23-53, March.
    2. Sean D. Campbell & Francis X. Diebold, 2005. "Weather Forecasting for Weather Derivatives," Journal of the American Statistical Association, American Statistical Association, vol. 100, pages 6-16, March.
    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. Dorje Brody & Joanna Syroka & Mihail Zervos, 2002. "Dynamical pricing of weather derivatives," Quantitative Finance, Taylor & Francis Journals, vol. 2(3), pages 189-198.
    5. M. Davis, 2001. "Pricing weather derivatives by marginal value," Quantitative Finance, Taylor & Francis Journals, vol. 1(3), pages 305-308, March.
    6. Helyette Geman & M. Leonardi, 2005. "Alternative Approaches to Weather Derivatives Pricing," Post-Print halshs-00144304, HAL.
    7. repec:dau:papers:123456789/1386 is not listed on IDEAS
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    Cited by:

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    2. Markus Hess, 2018. "Pricing Temperature Derivatives Under Weather Forecasts," International Journal of Theoretical and Applied Finance (IJTAF), World Scientific Publishing Co. Pte. Ltd., vol. 21(05), pages 1-34, August.
    3. Yuji Yamada & Takuji Matsumoto, 2021. "Going for Derivatives or Forwards? Minimizing Cashflow Fluctuations of Electricity Transactions on Power Markets," Energies, MDPI, vol. 14(21), pages 1-28, November.
    4. Groll, Andreas & López-Cabrera, Brenda & Meyer-Brandis, Thilo, 2016. "A consistent two-factor model for pricing temperature derivatives," Energy Economics, Elsevier, vol. 55(C), pages 112-126.

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