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On arbitrage-free pricing of weather derivatives based on fractional Brownian motion

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  • Fred Espen Benth

Abstract

We derive an arbitrage-free pricing dynamics for claims on temperature, where the temperature follows a fractional Ornstein-Uhlenbeck process. Using a fractional white noise calculus, one can express the dynamics as a special type of conditional expectation not coinciding with the classical one. Using a Fourier transformation technique, explicit expressions are derived for claims of European and average type, and it is shown that these pricing formulas are solutions of certain Black and Scholes partial differential equations. Our results partly confirm a conjecture made by Brody, Syroka and Zervos.

Suggested Citation

  • Fred Espen Benth, 2003. "On arbitrage-free pricing of weather derivatives based on fractional Brownian motion," Applied Mathematical Finance, Taylor & Francis Journals, vol. 10(4), pages 303-324.
  • Handle: RePEc:taf:apmtfi:v:10:y:2003:i:4:p:303-324
    DOI: 10.1080/1350486032000174628
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    Citations

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    Cited by:

    1. Neuenkirch, Andreas, 2008. "Optimal pointwise approximation of stochastic differential equations driven by fractional Brownian motion," Stochastic Processes and their Applications, Elsevier, vol. 118(12), pages 2294-2333, December.
    2. Wolfgang Karl Härdle & Brenda López-Cabrera & Matthias Ritter, 2012. "Forecast based Pricing of Weather Derivatives," SFB 649 Discussion Papers SFB649DP2012-027, Sonderforschungsbereich 649, Humboldt University, Berlin, Germany.
    3. Björk, Tomas & Hult, Henrik, 2005. "A Note on Wick Products and the Fractional Black-Scholes Model," SSE/EFI Working Paper Series in Economics and Finance 596, Stockholm School of Economics.
    4. Fred Benth & Wolfgang Karl Härdle & Brenda López Cabrera, 2009. "Pricing of Asian temperature risk," SFB 649 Discussion Papers SFB649DP2009-046, Sonderforschungsbereich 649, Humboldt University, Berlin, Germany.
    5. Hélène Hamisultane, 2006. "Pricing the Weather Derivatives in the Presence of Long Memory in Temperatures," Working Papers halshs-00079197, HAL.
    6. Høg, Espen P. & Frederiksen, Per H., 2006. "The Fractional Ornstein-Uhlenbeck Process: Term Structure Theory and Application," Finance Research Group Working Papers F-2006-01, University of Aarhus, Aarhus School of Business, Department of Business Studies.
    7. Xiao, Weilin & Zhang, Weiguo & Zhang, Xili & Chen, Xiaoyan, 2014. "The valuation of equity warrants under the fractional Vasicek process of the short-term interest rate," Physica A: Statistical Mechanics and its Applications, Elsevier, vol. 394(C), pages 320-337.
    8. Bishwal, Jaya P.N., 2008. "Large deviations in testing fractional Ornstein-Uhlenbeck models," Statistics & Probability Letters, Elsevier, vol. 78(8), pages 953-962, June.
    9. Rostek, Stefan & Schöbel, Rainer, 2006. "Risk preference based option pricing in a fractional Brownian market," Tübinger Diskussionsbeiträge 299, University of Tübingen, School of Business and Economics.
    10. FRED ESPEN BENTH & JŪRATĖ SALTYTĖ BENTH & STEEN KOEKEBAKKER, 2007. "Putting a Price on Temperature," Scandinavian Journal of Statistics, Danish Society for Theoretical Statistics;Finnish Statistical Society;Norwegian Statistical Association;Swedish Statistical Association, vol. 34(4), pages 746-767.
    11. repec:kap:annfin:v:13:y:2017:i:1:d:10.1007_s10436-016-0289-1 is not listed on IDEAS
    12. Stoyan V. Stoyanov & Yong Shin Kim & Svetlozar T. Rachev & Frank J. Fabozzi, 2017. "Option pricing for Informed Traders," Papers 1711.09445, arXiv.org.
    13. Esben Hoeg & Per Frederiksen, 2006. "The Fractional OU Process: Term Structure Theory and Application," Computing in Economics and Finance 2006 194, Society for Computational Economics.
    14. Rostek, S. & Schöbel, R., 2013. "A note on the use of fractional Brownian motion for financial modeling," Economic Modelling, Elsevier, vol. 30(C), pages 30-35.

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