Pricing Rainfall Derivatives at the CME
AbstractMany business people such as farmers and financial investors are affected by indirect losses caused by scarce or abundant rainfall. Because of the high potential of insuring rainfall risk, the Chicago Mercantile Exchange (CME) began trading rainfall derivatives in 2011. Compared to temperature derivatives, however, pricing rainfall derivatives is more difficult. In this article, we propose to model rainfall indices via a flexible type of distribution, namely the normal-inverse Gaussian distribution, which captures asymmetries and heavy-tail behaviour. The prices of rainfall futures are computed by employing the Esscher transform, a wellknown tool in actuarial science. This approach is flexible enough to price any rainfall contract and to adjust theoretical prices to market prices by using the calibrated market price of risk. This empirical analysis is conducted with U.S. precipitation data and CME futures data providing first results on the market price of risk for rainfall derivatives.
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Bibliographic InfoPaper provided by Sonderforschungsbereich 649, Humboldt University, Berlin, Germany in its series SFB 649 Discussion Papers with number SFB649DP2013-005.
Length: 27 pages
Date of creation: Jan 2013
Date of revision:
Weather derivatives; precipitation; Esscher transform; market price of risk;
Find related papers by JEL classification:
- G19 - Financial Economics - - General Financial Markets - - - Other
- G29 - Financial Economics - - Financial Institutions and Services - - - Other
- G22 - Financial Economics - - Financial Institutions and Services - - - Insurance; Insurance Companies
- Q59 - Agricultural and Natural Resource Economics; Environmental and Ecological Economics - - Environmental Economics - - - Other
This paper has been announced in the following NEP Reports:
- NEP-AGR-2013-02-03 (Agricultural Economics)
- NEP-ALL-2013-02-03 (All new papers)
- NEP-RMG-2013-02-03 (Risk Management)
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