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Pricing Weather Derivatives

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  • Richards, Timothy J.
  • Manfredo, Mark R.
  • Sanders, Dwight R.

Abstract

This paper presents a general method for pricing weather derivatives. Specification tests find that a temperature series for Fresno, California follows a mean-reverting Brownian motion process with discrete jumps and ARCH errors. Based on this process, we define an equilibrium pricing model for cooling degree day weather options. Comparing option prices estimated with three methods: a traditional burn-rate approach, a Black-Scholes-Merton approximation, and an equilibrium Monte Carlo simulation reveals significant differences. Equilibrium prices are preferred on theoretical grounds, so are used to demonstrate the usefulness of weather derivatives as risk management tools for California specialty crop growers.

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File URL: http://purl.umn.edu/28536
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Bibliographic Info

Paper provided by Arizona State University, Morrison School of Agribusiness and Resource Management in its series Working Papers with number 28536.

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Date of creation: 2004
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Handle: RePEc:ags:asumwp:28536

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Keywords: derivative; jump-diffusion process; mean-reversion; volatility; weather; Demand and Price Analysis;

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