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Fair Pricing of Weather Derivatives

This paper proposes a consistent benchmark approach to price weather derivatives. The growth optimal portfolio to price weather derivatives. The growth optimal portfolio is used as numeraire such that all benchmarked fair price processes are martingales. No measure transformation is needed for fair pricing. Since weather derivatives are traded in an incomplete market setting, standard hedging based pricing methods cannot be applied. For weather derivative payoffs that are independent from the value of the growth optimal portfolio it is shown that the classical actuarial pricing methodology is a particular case of the fair pricing concept. A discrete time model is constructed to approximate historical weather characteristics assuming Gaussian residuals. For particular weather derivatives their fair prices are derived.

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File URL: http://www.business.uts.edu.au/qfrc/research/research_papers/rp106.pdf
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Paper provided by Quantitative Finance Research Centre, University of Technology, Sydney in its series Research Paper Series with number 106.

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Date of creation: 01 Sep 2003
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Handle: RePEc:uts:rpaper:106
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Web page: http://www.qfrc.uts.edu.au/

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  1. Eckhard Platen, 2003. "Modeling the Volatility and Expected Value of a Diversified World Index," Research Paper Series 103, Quantitative Finance Research Centre, University of Technology, Sydney.
  2. Eckhard Platen, 2003. "Pricing and Hedging for Incomplete Jump Diffusion Benchmark Models," Research Paper Series 110, Quantitative Finance Research Centre, University of Technology, Sydney.
  3. Sean D. Campbell & Francis X. Diebold, 2005. "Weather Forecasting for Weather Derivatives," Journal of the American Statistical Association, American Statistical Association, vol. 100, pages 6-16, March.
  4. Eckhard Platen, 2001. "Arbitrage in Continuous Complete Markets," Research Paper Series 72, Quantitative Finance Research Centre, University of Technology, Sydney.
  5. I. Bajeux-Besnainou & R. Portait, 1997. "The numeraire portfolio: a new perspective on financial theory," The European Journal of Finance, Taylor & Francis Journals, vol. 3(4), pages 291-309.
  6. Fama, Eugene F & MacBeth, James D, 1974. "Long-Term Growth in a Short-Term Market," Journal of Finance, American Finance Association, vol. 29(3), pages 857-85, June.
  7. Black, Fischer & Scholes, Myron S, 1973. "The Pricing of Options and Corporate Liabilities," Journal of Political Economy, University of Chicago Press, vol. 81(3), pages 637-54, May-June.
  8. Eckhard Platen, 2003. "A Benchmark Framework for Risk Management," Research Paper Series 113, Quantitative Finance Research Centre, University of Technology, Sydney.
  9. Long, John Jr., 1990. "The numeraire portfolio," Journal of Financial Economics, Elsevier, vol. 26(1), pages 29-69, July.
  10. Norbert Hofmann & Eckhard Platen & Martin Schweizer, 1992. "Option Pricing Under Incompleteness and Stochastic Volatility," Mathematical Finance, Wiley Blackwell, vol. 2(3), pages 153-187.
  11. Hans Buhlmann & Eckhard Platen, 2002. "A Discrete Time Benchmark Approach for Finance and Insurance," Research Paper Series 74, Quantitative Finance Research Centre, University of Technology, Sydney.
  12. Eckhard Platen, 2003. "Diversified Portfolios in a Benchmark Framework," Research Paper Series 87, Quantitative Finance Research Centre, University of Technology, Sydney.
  13. David Heath & Eckhard Platen & Martin Schweizer, 2001. "A Comparison of Two Quadratic Approaches to Hedging in Incomplete Markets," Mathematical Finance, Wiley Blackwell, vol. 11(4), pages 385-413.
  14. Dirk Becherer, 2001. "The numeraire portfolio for unbounded semimartingales," Finance and Stochastics, Springer, vol. 5(3), pages 327-341.
  15. Takeaki Kariya, 2003. "Weather Risk Swap Valuation," KIER Working Papers 568, Kyoto University, Institute of Economic Research.
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