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The pricing of degree-day weather options

  • Calum G. Turvey

This paper presents a model and framework for pricing degree-day weather derivatives when the weather variable is a non-traded asset. Using daily weather data from 1840S1996, it is shown that a degree-day weather index exhibits stable volatility and satisfies the random walk hypothesis. The options prices from the recommended model are compared to a typical insurance-type model. The results show that the insurance model overprices the option value at-the-money, and this may explain why the bid-ask spread in the weather derivatives market is sometimes very large.

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Article provided by Emerald Group Publishing in its journal Agricultural Finance Review.

Volume (Year): 65 (2005)
Issue (Month): 1 (May)
Pages: 59-85

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Handle: RePEc:eme:afrpps:v:65:y:2005:i:1:p:59-85
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  1. Cox, John C. & Ross, Stephen A., 1976. "The valuation of options for alternative stochastic processes," Journal of Financial Economics, Elsevier, vol. 3(1-2), pages 145-166.
  2. Black, Fischer, 1976. "The pricing of commodity contracts," Journal of Financial Economics, Elsevier, vol. 3(1-2), pages 167-179.
  3. Lucas, Robert E, Jr, 1978. "Asset Prices in an Exchange Economy," Econometrica, Econometric Society, vol. 46(6), pages 1429-45, November.
  4. Black, Fischer & Scholes, Myron S, 1973. "The Pricing of Options and Corporate Liabilities," Journal of Political Economy, University of Chicago Press, vol. 81(3), pages 637-54, May-June.
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