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Implied Market Price of Weather Risk

Author

Listed:
  • Wolfgang Härdle
  • Brenda López Cabrera

Abstract

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.

Suggested Citation

  • Wolfgang Härdle & Brenda López Cabrera, 2009. "Implied Market Price of Weather Risk," SFB 649 Discussion Papers SFB649DP2009-001, Sonderforschungsbereich 649, Humboldt University, Berlin, Germany.
  • Handle: RePEc:hum:wpaper:sfb649dp2009-001
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    File URL: http://sfb649.wiwi.hu-berlin.de/papers/pdf/SFB649DP2009-001.pdf
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    References listed on IDEAS

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    1. Eckhard Platen & Jason West, 2004. "A Fair Pricing Approach to Weather Derivatives," Asia-Pacific Financial Markets, Springer;Japanese Association of Financial Economics and Engineering, vol. 11(1), pages 23-53, March.
    2. 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.
    3. 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.
    4. Hélène Hamisultane, 2007. "Extracting Information from the Market to Price the Weather Derivatives," Working Papers halshs-00079192, HAL.
    5. 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, August.
    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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    Citations

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    Cited by:

    1. 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.
    2. Benth, Fred Espen & Taib, Che Mohd Imran Che, 2013. "On the speed towards the mean for continuous time autoregressive moving average processes with applications to energy markets," Energy Economics, Elsevier, vol. 40(C), pages 259-268.
    3. Ahmet Göncü, 2013. "Comparison of temperature models using heating and cooling degree days futures," Journal of Risk Finance, Emerald Group Publishing, vol. 14(2), pages 159-178, February.
    4. Fred Espen Benth & Paul Kruhner, 2014. "Representation of infinite dimensional forward price models in commodity markets," Papers 1403.4111, arXiv.org.
    5. A. Alexandridis & A. Zapranis, 2013. "Wind Derivatives: Modeling and Pricing," Computational Economics, Springer;Society for Computational Economics, vol. 41(3), pages 299-326, March.
    6. Awdesch Melzer & Wolfgang K. Härdle & Brenda López Cabrera, 2017. "Pricing Green Financial Products," SFB 649 Discussion Papers SFB649DP2017-020, Sonderforschungsbereich 649, Humboldt University, Berlin, Germany.
    7. Ole E. Barndorff-Nielsen & Fred Espen Benth & Almut E. D. Veraart, 2013. "Modelling energy spot prices by volatility modulated L\'{e}vy-driven Volterra processes," Papers 1307.6332, arXiv.org.
    8. Joanna Janczura, 2014. "Pricing electricity derivatives within a Markov regime-switching model: a risk premium approach," Mathematical Methods of Operations Research, Springer;Gesellschaft für Operations Research (GOR);Nederlands Genootschap voor Besliskunde (NGB), vol. 79(1), pages 1-30, February.
    9. Maria Grith & Wolfgang K. Härdle & Alois Kneip & Heiko Wagner, 2016. "Functional Principal Component Analysis for Derivatives of Multivariate Curves," SFB 649 Discussion Papers SFB649DP2016-033, Sonderforschungsbereich 649, Humboldt University, Berlin, Germany.
    10. Dorfleitner, Gregor & Wimmer, Maximilian, 2010. "The pricing of temperature futures at the Chicago Mercantile Exchange," Journal of Banking & Finance, Elsevier, vol. 34(6), pages 1360-1370, June.
    11. Brenda López Cabrera & Martin Odening & Matthias Ritter, 2013. "Pricing Rainfall Derivatives at the CME," SFB 649 Discussion Papers SFB649DP2013-005, Sonderforschungsbereich 649, Humboldt University, Berlin, Germany.
    12. Ahčan, Aleš, 2012. "Statistical analysis of model risk concerning temperature residuals and its impact on pricing weather derivatives," Insurance: Mathematics and Economics, Elsevier, vol. 50(1), pages 131-138.
    13. Groll, Andreas & López-Cabrera, Brenda & Meyer-Brandis, Thilo, 2016. "A consistent two-factor model for pricing temperature derivatives," Energy Economics, Elsevier, vol. 55(C), pages 112-126.
    14. Matthias Ritter & Oliver Mußhoff & Martin Odening, 2010. "Meteorological forecasts and the pricing of weather derivatives," SFB 649 Discussion Papers SFB649DP2010-043, Sonderforschungsbereich 649, Humboldt University, Berlin, Germany.
    15. L. Kermiche & N. Vuillermet, 2016. "Weather derivatives structuring and pricing: a sustainable agricultural approach in Africa," Applied Economics, Taylor & Francis Journals, vol. 48(2), pages 165-177, January.
    16. 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.
    17. Ragnhild Noven & Almut Veraart & Axel Gandy, 2015. "A Lévy-driven rainfall model with applications to futures pricing," AStA Advances in Statistical Analysis, Springer;German Statistical Society, vol. 99(4), pages 403-432, October.
    18. repec:spr:compst:v:79:y:2014:i:1:p:1-30 is not listed on IDEAS
    19. Mengmeng Guo & Lhan Zhou & Jianhua Z. Huang & Wolfgang Karl Härdle, 2013. "Functional Data Analysis of Generalized Quantile Regressions," SFB 649 Discussion Papers SFB649DP2013-001, Sonderforschungsbereich 649, Humboldt University, Berlin, Germany.

    More about this item

    Keywords

    Weather derivatives; weather risk; weather forecasting; seasonality; continuous autoregressive model; stochastic variance; CAT index; CDD index; HDD index; market price of risk; risk premium; CME;

    JEL classification:

    • G19 - Financial Economics - - General Financial Markets - - - Other
    • G29 - Financial Economics - - Financial Institutions and Services - - - Other
    • N26 - Economic History - - Financial Markets and Institutions - - - Latin America; Caribbean
    • N56 - Economic History - - Agriculture, Natural Resources, Environment and Extractive Industries - - - Latin America; Caribbean
    • Q29 - Agricultural and Natural Resource Economics; Environmental and Ecological Economics - - Renewable Resources and Conservation - - - Other
    • Q54 - Agricultural and Natural Resource Economics; Environmental and Ecological Economics - - Environmental Economics - - - Climate; Natural Disasters and their Management; Global Warming

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