Implied Market Price of Weather Risk

Wolfgang Karl Härdle and Brenda López Cabrera

No SFB649DP2009-001, SFB 649 Discussion Papers from Humboldt University, Collaborative Research Center 649

Abstract: Weather influences our daily lives and choices and has an enormous impact on corporate revenues and earnings. Weather derivatives dier 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 dierent 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.

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 (search for similar items in EconPapers)
JEL-codes: G19 G29 N26 N56 Q29 Q54 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-rmg
Date: 2009-01
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