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Forecast based Pricing of Weather Derivatives

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Author Info

  • Wolfgang Karl Härdle
  • Brenda López-Cabrera
  • Matthias Ritter

Abstract

Forecasting based pricing of Weather Derivatives (WDs) is a new approach in valuation of contingent claims on nontradable underlyings. Standard techniques are based on historical weather data. Forward-looking information such as meteorological forecasts or the implied market price of risk (MPR) are often not incorporated. We adopt a risk neutral approach (for each location) that allows the incorporation of meteorological forecasts in the framework of WD pricing. We study weather Risk Premiums (RPs) implied from either the information MPR gain or the meteorological forecasts. The size of RPs is interesting for investors and issuers of weather contracts to take advantages of geographic diversification, hedging effects and price determinations. By conducting an empirical analysis to London and Rome WD data traded at the Chicago Mercantile Exchange (CME), we find out that either incorporating the MPR or the forecast outperforms the standard pricing techniques.

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Bibliographic Info

Paper provided by Sonderforschungsbereich 649, Humboldt University, Berlin, Germany in its series SFB 649 Discussion Papers with number SFB649DP2012-027.

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Length: 25 pages
Date of creation: Mar 2012
Date of revision:
Handle: RePEc:hum:wpaper:sfb649dp2012-027

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Keywords: Weather derivatives; seasonal variation; temperature; risk premia;

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References

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  1. Sean D. Campbell & Francis X. Diebold, 2002. "Weather Forecasting for Weather Derivatives," Center for Financial Institutions Working Papers, Wharton School Center for Financial Institutions, University of Pennsylvania 02-42, Wharton School Center for Financial Institutions, University of Pennsylvania.
  2. Francis X. Diebold & Atsushi Inoue, 2000. "Long Memory and Regime Switching," NBER Technical Working Papers, National Bureau of Economic Research, Inc 0264, National Bureau of Economic Research, Inc.
  3. Wolfgang Härdle & Brenda López Cabrera, 2009. "Implied Market Price of Weather Risk," SFB 649 Discussion Papers, Sonderforschungsbereich 649, Humboldt University, Berlin, Germany SFB649DP2009-001, Sonderforschungsbereich 649, Humboldt University, Berlin, Germany.
  4. Fred Espen Benth, 2003. "On arbitrage-free pricing of weather derivatives based on fractional Brownian motion," Applied Mathematical Finance, Taylor & Francis Journals, Taylor & Francis Journals, vol. 10(4), pages 303-324.
  5. Fred Benth & Wolfgang Karl Härdle & Brenda López Cabrera, 2009. "Pricing of Asian temperature risk," SFB 649 Discussion Papers, Sonderforschungsbereich 649, Humboldt University, Berlin, Germany SFB649DP2009-046, Sonderforschungsbereich 649, Humboldt University, Berlin, Germany.
  6. Peter Alaton & Boualem Djehiche & David Stillberger, 2002. "On modelling and pricing weather derivatives," Applied Mathematical Finance, Taylor & Francis Journals, Taylor & Francis Journals, vol. 9(1), pages 1-20.
  7. 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.
  8. Matthias Ritter & Oliver Mußhoff & Martin Odening, 2010. "Meteorological forecasts and the pricing of weather derivatives," SFB 649 Discussion Papers, Sonderforschungsbereich 649, Humboldt University, Berlin, Germany SFB649DP2010-043, Sonderforschungsbereich 649, Humboldt University, Berlin, Germany.
  9. Dorfleitner, Gregor & Wimmer, Maximilian, 2010. "The pricing of temperature futures at the Chicago Mercantile Exchange," Journal of Banking & Finance, Elsevier, Elsevier, vol. 34(6), pages 1360-1370, June.
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Cited by:
  1. Füss, Roland & Mahringer, Steffen & Prokopczuk, Marcel, 2013. "Electricity Derivatives Pricing with Forward-Looking Information," Working Papers on Finance, University of St. Gallen, School of Finance 1317, University of St. Gallen, School of Finance.
  2. López Cabrera, Brenda & Odening, Martin & Ritter, Matthias, 2013. "Pricing rainfall futures at the CME," Journal of Banking & Finance, Elsevier, Elsevier, vol. 37(11), pages 4286-4298.
  3. Brenda López Cabrera & Martin Odening & Matthias Ritter, 2013. "Pricing Rainfall Derivatives at the CME," SFB 649 Discussion Papers, Sonderforschungsbereich 649, Humboldt University, Berlin, Germany SFB649DP2013-005, Sonderforschungsbereich 649, Humboldt University, Berlin, Germany.
  4. Andreas Groll & Brenda López-Cabrera & Thilo Meyer-Brandis, 2014. "A consistent two-factor model for pricing temperature derivatives," SFB 649 Discussion Papers, Sonderforschungsbereich 649, Humboldt University, Berlin, Germany SFB649DP2014-006, Sonderforschungsbereich 649, Humboldt University, Berlin, Germany.

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