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Implied Market Price of Weather Risk

  • Wolfgang Härdle
  • Brenda López Cabrera

Weather influences our daily lives and choices and has an enormous impact on corporate revenues and earnings. Weather derivatives di er from most derivatives in that the underlying weather cannot be traded and their market is relatively illiquid. The weather derivative market is therefore incomplete. This paper implements a pricing methodology for weather derivatives that can increase the precision of measuring weather risk. We have applied continous autoregressive models (CAR) with seasonal variation to model the temperature in Berlin and with that to get the explicite nature of non-arbitrage prices for temperature derivatives. We infer the implied market price from Berlin cumulative monthly temperature futures that are traded at the Chicago Mercantile Exchange (CME), which is an important parameter of the associated equivalent martingale measures used to price and hedge weather future/options in the market. We propose to study the market price of risk, not only as a piecewise constant linear function, but also as a time dependent object. In all of the previous cases, we found that the market price of weather risk is di erent from zero and shows a seasonal structure. With the extract information we price other exotic options, such as cooling/heating degree day temperatures and non-standard maturity contracts.

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File URL: http://sfb649.wiwi.hu-berlin.de/papers/pdf/SFB649DP2009-001.pdf
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Paper provided by Sonderforschungsbereich 649, Humboldt University, Berlin, Germany in its series SFB 649 Discussion Papers with number SFB649DP2009-001.

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Length: 35 pages
Date of creation: Jan 2009
Date of revision:
Handle: RePEc:hum:wpaper:sfb649dp2009-001
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  1. Hung‐Hsi Huang & Yung‐Ming Shiu & Pei‐Syun Lin, 2008. "HDD and CDD option pricing with market price of weather risk for Taiwan," Journal of Futures Markets, John Wiley & Sons, Ltd., vol. 28(8), pages 790-814, 08.
  2. 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.
  3. Hélène Hamisultane, 2007. "Extracting Information from the Market to Price the Weather Derivatives," Working Papers halshs-00079192, HAL.
  4. 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.
  5. Eckhard Platen & Jason West, 2003. "Fair Pricing of Weather Derivatives," Research Paper Series 106, Quantitative Finance Research Centre, University of Technology, Sydney.
  6. Martin Odening & Oliver Musshoff & Wei Xu, 2007. "Analysis of rainfall derivatives using daily precipitation models: opportunities and pitfalls," Agricultural Finance Review, Emerald Group Publishing, vol. 67(1), pages 135-156, May.
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