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Dynamical pricing of weather derivatives

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  • Dorje Brody
  • Joanna Syroka
  • Mihail Zervos

Abstract

The dynamics of temperature can be modelled by means of a stochastic process known as fractional Brownian motion. Based on this empirical observation, we characterize temperature dynamics by a fractional Ornstein-Uhlenbeck process. This model is used to price two types of contingent claims: one based on heating and cooling degree days, and one based on cumulative temperature. We derive analytic expressions for the expected discounted payoffs of such derivatives, and discuss the dependence of the results on the fractionality of the temperature dynamics.

Suggested Citation

  • Dorje Brody & Joanna Syroka & Mihail Zervos, 2002. "Dynamical pricing of weather derivatives," Quantitative Finance, Taylor & Francis Journals, vol. 2(3), pages 189-198.
  • Handle: RePEc:taf:quantf:v:2:y:2002:i:3:p:189-198 DOI: 10.1088/1469-7688/2/3/302
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    1. Prema-chandra Athukorala & Satish Chand, 1998. "Trade Orientation and Productivity Gains from International Production: A Study of Overseas Operations of US Multinationals," Departmental Working Papers 1998-02, The Australian National University, Arndt-Corden Department of Economics.
    2. Merton H. Miller & Franco Modigliani, 1961. "Dividend Policy, Growth, and the Valuation of Shares," The Journal of Business, University of Chicago Press, vol. 34, pages 411-411.
    3. A. C. Miller, 1902. "Fiscal Reciprocity," Journal of Political Economy, University of Chicago Press, vol. 10, pages 255-255.
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