Implied Market Price of Weather Risk
AbstractWeather influences our daily lives and choices and has an enormous impact on corporate revenues and earnings. Weather derivatives dier from most derivatives in that the underlying weather cannot be traded and their market is relatively illiquid. The weather derivative market is therefore incomplete. This paper implements a pricing methodology for weather derivatives that can increase the precision of measuring weather risk. We have applied continous autoregressive models (CAR) with seasonal variation to model the temperature in Berlin and with that to get the explicite nature of non-arbitrage prices for temperature derivatives. We infer the implied market price from Berlin cumulative monthly temperature futures that are traded at the Chicago Mercantile Exchange (CME), which is an important parameter of the associated equivalent martingale measures used to price and hedge weather future/options in the market. We propose to study the market price of risk, not only as a piecewise constant linear function, but also as a time dependent object. In all of the previous cases, we found that the market price of weather risk is dierent from zero and shows a seasonal structure. With the extract information we price other exotic options, such as cooling/heating degree day temperatures and non-standard maturity contracts.
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Bibliographic InfoPaper provided by Sonderforschungsbereich 649, Humboldt University, Berlin, Germany in its series SFB 649 Discussion Papers with number SFB649DP2009-001.
Length: 35 pages
Date of creation: Jan 2009
Date of revision:
Weather derivatives; weather risk; weather forecasting; seasonality; continuous autoregressive model; stochastic variance; CAT index; CDD index; HDD index; market price of risk; risk premium; CME;
Find related papers by JEL classification:
- G19 - Financial Economics - - General Financial Markets - - - Other
- G29 - Financial Economics - - Financial Institutions and Services - - - Other
- N26 - Economic History - - Financial Markets and Institutions - - - Latin America; Caribbean
- N56 - Economic History - - Agriculture, Natural Resources, Environment and Extractive Industries - - - Latin America; Caribbean
- Q29 - Agricultural and Natural Resource Economics; Environmental and Ecological Economics - - Renewable Resources and Conservation - - - Other
- Q54 - Agricultural and Natural Resource Economics; Environmental and Ecological Economics - - Environmental Economics - - - Climate; Natural Disasters
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- Richards, Timothy J. & Manfredo, Mark R. & Sanders, Dwight R., 2004. "Pricing Weather Derivatives," Working Papers 28536, Arizona State University, Morrison School of Agribusiness and Resource Management.
- Hélène Hamisultane, 2007. "Extracting Information from the Market to Price the Weather Derivatives," Working Papers halshs-00079192, HAL.
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- Martin Odening & Oliver Musshoff & Wei Xu, 2007. "Analysis of rainfall derivatives using daily precipitation models: opportunities and pitfalls," Agricultural Finance Review, Emerald Group Publishing, vol. 67(1), pages 135-156, May.
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- 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.
- Brenda López Cabrera & Martin Odening & Matthias Ritter, 2013. "Pricing Rainfall Derivatives at the CME," SFB 649 Discussion Papers SFB649DP2013-005, Sonderforschungsbereich 649, Humboldt University, Berlin, Germany.
- 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.
- Matthias Ritter & Oliver Mußhoff & Martin Odening, 2010. "Meteorological forecasts and the pricing of weather derivatives," SFB 649 Discussion Papers SFB649DP2010-043, Sonderforschungsbereich 649, Humboldt University, Berlin, Germany.
- Mengmeng Guo & Lhan Zhou & Jianhua Z. Huang & Wolfgang Karl Härdle, 2013. "Functional Data Analysis of Generalized Quantile Regressions," SFB 649 Discussion Papers SFB649DP2013-001, Sonderforschungsbereich 649, Humboldt University, Berlin, Germany.
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