IDEAS home Printed from https://ideas.repec.org/a/gam/jijfss/v5y2017i4p23-d115840.html
   My bibliography  Save this article

A Dynamic Programming Approach for Pricing Weather Derivatives under Issuer Default Risk

Author

Listed:
  • Wolfgang Karl Härdle

    () (Ladislaus von Bortkiewicz Chair of Statistics, School of Business and Economics, Humboldt-Universität zu Berlin, Unter den Linden 6, 10099 Berlin, Germany
    Sim Kee Boon Institute for Financial Economics, Singapore Management University, 90 Stamford Road, 6th Level, School of Economics, Singapore 178903, Singapore
    Current address: Ladislaus von Bortkiewicz Chair of Statistics, School of Business and Economics, Humboldt-Universität zu Berlin, Unter den Linden 6, 10099 Berlin, Germany.
    These authors contributed equally to this work.)

  • Maria Osipenko

    () (Ladislaus von Bortkiewicz Chair of Statistics, School of Business and Economics, Humboldt-Universität zu Berlin, Unter den Linden 6, 10099 Berlin, Germany
    These authors contributed equally to this work.)

Abstract

Weather derivatives are contingent claims with payoff based on a pre-specified weather index. Firms exposed to weather risk can transfer it to financial markets via weather derivatives. We develop a utility-based model for pricing baskets of weather derivatives under default risk on the issuer side in over-the-counter markets. In our model, agents maximise the expected utility of their terminal wealth, while they dynamically rebalance their weather portfolios over a finite investment horizon. Using dynamic programming approach, we obtain semi-closed forms for the equilibrium prices of weather derivatives and for the optimal strategies of the agents. We give an example on how to price rainfall derivatives on selected stations in China in the universe of a financial investor and a weather exposed crop insurer.

Suggested Citation

  • Wolfgang Karl Härdle & Maria Osipenko, 2017. "A Dynamic Programming Approach for Pricing Weather Derivatives under Issuer Default Risk," International Journal of Financial Studies, MDPI, Open Access Journal, vol. 5(4), pages 1-18, October.
  • Handle: RePEc:gam:jijfss:v:5:y:2017:i:4:p:23-:d:115840
    as

    Download full text from publisher

    File URL: http://www.mdpi.com/2227-7072/5/4/23/pdf
    Download Restriction: no

    File URL: http://www.mdpi.com/2227-7072/5/4/23/
    Download Restriction: no

    References listed on IDEAS

    as
    1. Gunther Leobacher & Philip Ngare, 2011. "On Modelling and Pricing Rainfall Derivatives with Seasonality," Applied Mathematical Finance, Taylor & Francis Journals, vol. 18(1), pages 71-91.
    2. Cao, M. & Wei, J., 1999. "Pricing Weather Derivative : An Equilibrium Approach," Rotman School of Management - Finance 99-002, Rotman School of Management, University of Toronto.
    3. Linda L. Golden & Mulong Wang & Chuanhou Yang, 2007. "Handling Weather Related Risks Through the Financial Markets: Considerations of Credit Risk, Basis Risk, and Hedging," Journal of Risk & Insurance, The American Risk and Insurance Association, vol. 74(2), pages 319-346.
    4. Ulrich Horst & Matthias Müller, 2007. "On the Spanning Property of Risk Bonds Priced by Equilibrium," Mathematics of Operations Research, INFORMS, vol. 32(4), pages 784-807, November.
    5. Francisco Pérez-González & Hayong Yun, 2013. "Risk Management and Firm Value: Evidence from Weather Derivatives," Journal of Finance, American Finance Association, vol. 68(5), pages 2143-2176, October.
    6. Allen, Franklin & Postlewaite, Andrew, 1984. " Rational Expectations and the Measurement of a Stock's Elasticity of Demand," Journal of Finance, American Finance Association, vol. 39(4), pages 1119-1125, September.
    7. David Heath & Robert Jarrow & Andrew Morton, 2008. "Bond Pricing And The Term Structure Of Interest Rates: A New Methodology For Contingent Claims Valuation," World Scientific Book Chapters,in: Financial Derivatives Pricing Selected Works of Robert Jarrow, chapter 13, pages 277-305 World Scientific Publishing Co. Pte. Ltd..
    8. Robert A. Jarrow & Stuart M. Turnbull, 2008. "Pricing Derivatives on Financial Securities Subject to Credit Risk," World Scientific Book Chapters,in: Financial Derivatives Pricing Selected Works of Robert Jarrow, chapter 17, pages 377-409 World Scientific Publishing Co. Pte. Ltd..
    9. Peter Alaton & Boualem Djehiche & David Stillberger, 2002. "On modelling and pricing weather derivatives," Applied Mathematical Finance, Taylor & Francis Journals, vol. 9(1), pages 1-20.
    10. López Cabrera, Brenda & Odening, Martin & Ritter, Matthias, 2013. "Pricing rainfall futures at the CME," Journal of Banking & Finance, Elsevier, vol. 37(11), pages 4286-4298.
    11. Lucas, Robert E, Jr, 1978. "Asset Prices in an Exchange Economy," Econometrica, Econometric Society, vol. 46(6), pages 1429-1445, November.
    12. repec:wsi:ijtafx:v:08:y:2005:i:07:n:s0219024905003311 is not listed on IDEAS
    13. Wu, Yang-Che & Chung, San-Lin, 2010. "Catastrophe risk management with counterparty risk using alternative instruments," Insurance: Mathematics and Economics, Elsevier, vol. 47(2), pages 234-245, October.
    14. Calum G. Turvey & Rong Kong, 2010. "Weather risk and the viability of weather insurance in China's Gansu, Shaanxi, and Henan provinces," China Agricultural Economic Review, Emerald Group Publishing, vol. 2(1), pages 5-24, February.
    15. Hull, John & White, Alan, 1995. "The impact of default risk on the prices of options and other derivative securities," Journal of Banking & Finance, Elsevier, vol. 19(2), pages 299-322, May.
    Full references (including those not matched with items on IDEAS)

    More about this item

    Keywords

    dynamic programming; pricing; risk management;

    JEL classification:

    • G1 - Financial Economics - - General Financial Markets
    • G2 - Financial Economics - - Financial Institutions and Services
    • G3 - Financial Economics - - Corporate Finance and Governance
    • F2 - International Economics - - International Factor Movements and International Business
    • F3 - International Economics - - International Finance
    • F41 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Open Economy Macroeconomics
    • F42 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - International Policy Coordination and Transmission

    Statistics

    Access and download statistics

    Corrections

    All material on this site has been provided by the respective publishers and authors. You can help correct errors and omissions. When requesting a correction, please mention this item's handle: RePEc:gam:jijfss:v:5:y:2017:i:4:p:23-:d:115840. See general information about how to correct material in RePEc.

    For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (XML Conversion Team). General contact details of provider: http://www.mdpi.com/ .

    If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

    If CitEc recognized a reference but did not link an item in RePEc to it, you can help with this form .

    If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your RePEc Author Service profile, as there may be some citations waiting for confirmation.

    Please note that corrections may take a couple of weeks to filter through the various RePEc services.

    IDEAS is a RePEc service hosted by the Research Division of the Federal Reserve Bank of St. Louis . RePEc uses bibliographic data supplied by the respective publishers.