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A consistent two-factor model for pricing temperature derivatives

Author

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  • Groll, Andreas
  • López-Cabrera, Brenda
  • Meyer-Brandis, Thilo

Abstract

In the past decade, the Chicago Mercantile Exchange began to trade weather derivatives to hedge weather risk. The pricing of weather derivatives is challenging since the underlying is not tradable and thus classical arbitrage approaches have to be used with caution. In typical pricing approaches all information available to the market is assumed to be incorporated in the underlying and thus forward-looking information about non-tradable assets such as meteorological forecasts is often ignored. In this article, we analyze a new pricing methodology for temperature derivatives that accounts for forward-looking information. More precisely, we provide an empirical back-up for the theoretical framework of so-called consistent factor models for temperature forecast curves introduced previously in the literature and put this pricing approach into practice. First, we perform a thorough statistical analysis of meteorological forecast curve data. Second, based on this analysis we propose a specific consistent two-factor model, derive explicit temperature derivative prices, and calibrate the market price of risk (MPR). The power of the model is demonstrated against alternative pricing models. This confirms that at least parts of the irregularity of the MPR observed in earlier studies are not due to irregular risk perception but rather due to information misspecification.

Suggested Citation

  • Groll, Andreas & López-Cabrera, Brenda & Meyer-Brandis, Thilo, 2016. "A consistent two-factor model for pricing temperature derivatives," Energy Economics, Elsevier, vol. 55(C), pages 112-126.
  • Handle: RePEc:eee:eneeco:v:55:y:2016:i:c:p:112-126
    DOI: 10.1016/j.eneco.2015.12.020
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    References listed on IDEAS

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    1. 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.
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    5. 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.
    6. Jewson,Stephen & Brix,Anders, 2005. "Weather Derivative Valuation," Cambridge Books, Cambridge University Press, number 9780521843713, April.
    7. Benth, Fred Espen & Cartea, Álvaro & Kiesel, Rüdiger, 2008. "Pricing forward contracts in power markets by the certainty equivalence principle: Explaining the sign of the market risk premium," Journal of Banking & Finance, Elsevier, vol. 32(10), pages 2006-2021, October.
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    Cited by:

    1. Awdesch Melzer & Wolfgang K. Härdle & Brenda López Cabrera, 2017. "Pricing Green Financial Products," SFB 649 Discussion Papers SFB649DP2017-020, Sonderforschungsbereich 649, Humboldt University, Berlin, Germany.

    More about this item

    Keywords

    Factor models; Consistency; Pricing and hedging; Weather derivatives; Market price of risk;

    JEL classification:

    • C49 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods: Special Topics - - - Other
    • C13 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods and Methodology: General - - - Estimation: General
    • 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; Actuarial Studies
    • Q59 - Agricultural and Natural Resource Economics; Environmental and Ecological Economics - - Environmental Economics - - - Other

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