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A consistent two-factor model for pricing temperature derivatives

  • Andreas Groll
  • Brenda López-Cabrera
  • Thilo Meyer-Brandis

We analyze a consistent two-factor model for pricing temperature derivatives that incorporates the forward looking information available in the market by specifying a model for the dynamics of the complete meteorological forecast curve. The two-factor model is a generalization of the Nelson-Siegel curve model by allowing factors with mean-reversion to a stochastic mean for structural changes and seasonality for periodic patterns. Based on the outcomes of a statistical analysis of forecast data we conclude that the two-factor model captures well the stylized features of temperature forecast curves. In particular, a functional principal component analysis reveals that the model re ects reasonably well the dynamical structure of forecast curves by decomposing their shapes into a tilting and a bending factor. We continue by developing an estimation procedure for the model, before we derive explicit prices for temperature derivatives and calibrate the market price of risk (MPR) from temperature futures derivatives (CAT, HDD, CDD) traded at the Chicago Mercantile Exchange (CME). The factor model shows that the behavior of the implied MPR for futures traded in and out of the measurement period is more stable than other estimates obtained in the literature. This con rms that at least parts of the irregularity of the MPR is not due to irregular risk perception but rather due to information misspecification. Similar to temperature derivatives, this approach can be used for pricing other non-tradable assets.

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Paper provided by Sonderforschungsbereich 649, Humboldt University, Berlin, Germany in its series SFB 649 Discussion Papers with number SFB649DP2014-006.

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Length: 42 pages
Date of creation: Jan 2014
Date of revision:
Handle: RePEc:hum:wpaper:sfb649dp2014-006
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  1. Wolfgang Härdle & Brenda López Cabrera, 2009. "Implied Market Price of Weather Risk," SFB 649 Discussion Papers SFB649DP2009-001, Sonderforschungsbereich 649, Humboldt University, Berlin, Germany.
  2. 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.
  3. Fred Espen Benth & Alvaro Cartea & Ruediger Kiesel, 2006. "Pricing Forward Contracts in Power Markets by the Certainty Equivalence Principle: Explaining the Sign of the Market Risk Premium," Birkbeck Working Papers in Economics and Finance 0611, Birkbeck, Department of Economics, Mathematics & Statistics.
  4. Jewson,Stephen & Brix,Anders, 2005. "Weather Derivative Valuation," Cambridge Books, Cambridge University Press, number 9780521843713.
  5. Dwight R. Sanders, 2004. "Pricing Weather Derivatives," American Journal of Agricultural Economics, Agricultural and Applied Economics Association, vol. 86(4), pages 1005-1017.
  6. 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.
  7. 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.
  8. Benth, Fred Espen & Biegler-König, Richard & Kiesel, Rüdiger, 2013. "An empirical study of the information premium on electricity markets," Energy Economics, Elsevier, vol. 36(C), pages 55-77.
  9. Campbell, Sean D. & Diebold, Francis X., 2004. "Weather forecasting for weather derivatives," CFS Working Paper Series 2004/10, Center for Financial Studies (CFS).
  10. 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.
  11. Nelson, Charles R & Siegel, Andrew F, 1987. "Parsimonious Modeling of Yield Curves," The Journal of Business, University of Chicago Press, vol. 60(4), pages 473-89, October.
  12. 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.
  13. 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.
  14. Han Shang, 2014. "A survey of functional principal component analysis," AStA Advances in Statistical Analysis, Springer, vol. 98(2), pages 121-142, April.
  15. Manfred Gilli & Stefan Große & Enrico Schumann, 2010. "Calibrating the Nelson–Siegel–Svensson model," Working Papers 031, COMISEF.
  16. Wolfgang Karl Härdle & Brenda López Cabrera & Ostap Okhrin & Weining Wang, 2011. "Localising temperature risk," SFB 649 Discussion Papers SFB649DP2011-001, Sonderforschungsbereich 649, Humboldt University, Berlin, Germany.
  17. Philipp Hell & Thilo Meyer-Brandis & Thorsten Rheinländer, 2012. "Consistent Factor Models For Temperature Markets," International Journal of Theoretical and Applied Finance (IJTAF), World Scientific Publishing Co. Pte. Ltd., vol. 15(04), pages 1250027-1-1.
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