CONSISTENT FACTOR MODELS FOR TEMPERATURE MARKETS

Philipp Hell (), Thilo Meyer-Brandis () and Thorsten Rheinländer ()
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Philipp Hell: Mathematical Institute, University of Munich, Theresienstrasse 39, 80333 Munich, Germany
Thilo Meyer-Brandis: Mathematical Institute, University of Munich, Theresienstrasse 39, 80333 Munich, Germany
Thorsten Rheinländer: Department of Statistics, London School of Economics and Political Science, Houghton Street, London WC2A 2AE, UK

International Journal of Theoretical and Applied Finance (IJTAF), 2012, vol. 15, issue 04, 1-24

Abstract: We propose an approach for pricing and hedging weather derivatives based on including forward looking information about the temperature available to the market. This is achieved by modeling temperature forecasts by a finite dimensional factor model. Temperature dynamics are then inferred in the short end. In analogy to interest rate theory, we establish conditions which guarantee consistency of a factor model with the martingale dynamics of temperature forecasts. Finally, we consider a specific two-factor model and examine in more detail pricing and hedging of weather derivatives in this context.

Keywords: Temperature models; temperature markets; factor models; consistency; temperature derivatives; pricing and hedging (search for similar items in EconPapers)
Date: 2012
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Citations: View citations in EconPapers (5)

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DOI: 10.1142/S0219024912500276

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