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Which Method for Pricing Weather Derivatives ?

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  • Hélène Hamisultane

    ()
    (EconomiX - CNRS : UMR7166 - Université de Paris X - Nanterre)

Abstract

Since the introduction of the first weather derivative in the United-States in 1997, a significant number of work was directed towards the pricing of this product and the modelling of the daily average temperature which characterizes most of the traded weather instruments. The weather derivatives were created to enable companies to hedge against climate risks. They respond more to a need to cover seasonal variations which may cause loss of profits for companies than to a coverage need in property damage. Despite the abundance of work on the topic, no consensus has emerged so far about the methodology for evaluating weather derivatives. The major problems of these instruments are on one hand, they are based on an meteorological index that is not traded on financial market which does not allow the use of traditional pricing methods and on the other hand, it is difficult to get round this obstacle by susbtituting the underlying for a linked exchanged security since the weather index is weakly correlated with prices of other financial assets. To further the question of evaluation, we propose in this paper to, firstly, shed light on the difficulties of implementing the three major pricing approaches suggested in the literature for the weather derivatives (actuarial, arbitrage-free and consumption-based methods) and, secondly, to compute the prices of a weather contract by the three methodologies for comparison.

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Paper provided by HAL in its series Working Papers with number halshs-00355856.

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Date of creation: Jul 2008
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Handle: RePEc:hal:wpaper:halshs-00355856

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Related research

Keywords: weather derivatives; arbitrage-free pricing method; actuarial pricing approach; consumption-based pricing model; risk-neutral distribution; market price of risk; finite difference method; Monte-Carlo simulations.;

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  1. Black, Fischer & Scholes, Myron S, 1973. "The Pricing of Options and Corporate Liabilities," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 81(3), pages 637-54, May-June.
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  3. Mankiw, N.G. & Zeldes, S.P., 1990. "The Consumption Of Stockholders And Non-Stockholders," Weiss Center Working Papers, Wharton School - Weiss Center for International Financial Research 23-90, Wharton School - Weiss Center for International Financial Research.
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  7. Cox, John C. & Ross, Stephen A. & Rubinstein, Mark, 1979. "Option pricing: A simplified approach," Journal of Financial Economics, Elsevier, Elsevier, vol. 7(3), pages 229-263, September.
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  9. Mehra, Rajnish & Prescott, Edward C., 1985. "The equity premium: A puzzle," Journal of Monetary Economics, Elsevier, Elsevier, vol. 15(2), pages 145-161, March.
  10. Fred Espen Benth & Jurate Saltyte-Benth, 2005. "Stochastic Modelling of Temperature Variations with a View Towards Weather Derivatives," Applied Mathematical Finance, Taylor & Francis Journals, Taylor & Francis Journals, vol. 12(1), pages 53-85.
  11. Cox, John C & Ingersoll, Jonathan E, Jr & Ross, Stephen A, 1985. "An Intertemporal General Equilibrium Model of Asset Prices," Econometrica, Econometric Society, Econometric Society, vol. 53(2), pages 363-84, March.
  12. Eckhard Platen & Jason West, 2004. "A Fair Pricing Approach to Weather Derivatives," Asia-Pacific Financial Markets, Springer, Springer, vol. 11(1), pages 23-53, March.
  13. Hélène Hamisultane, 2007. "Utility-based Pricing of the Weather Derivatives," Working Papers halshs-00088701, HAL.
  14. Marco Frittelli, 2000. "The Minimal Entropy Martingale Measure and the Valuation Problem in Incomplete Markets," Mathematical Finance, Wiley Blackwell, Wiley Blackwell, vol. 10(1), pages 39-52.
  15. Jackwerth, Jens Carsten & Rubinstein, Mark, 1996. " Recovering Probability Distributions from Option Prices," Journal of Finance, American Finance Association, American Finance Association, vol. 51(5), pages 1611-32, December.
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