Weather derivatives pricing using regime switching model

Evarest Emmanuel (), Berntsson Fredrik (), Singull Martin () and Yang Xiangfeng ()
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Evarest Emmanuel: Department of Mathematics, Linköping University, 581 83 Linköping, Sweden; and Department of Mathematics, University of Dar Es Salaam, P.O. Box 35062, Dar Es Salaam, Tanzania
Berntsson Fredrik: Department of Mathematics, Linköping University, 581 83 Linköping, Sweden
Singull Martin: Department of Mathematics, Linköping University, 581 83 Linköping, Sweden
Yang Xiangfeng: Department of Mathematics, Linköping University, 581 83 Linköping, Sweden

Monte Carlo Methods and Applications, 2018, vol. 24, issue 1, 13-27

Abstract: In this study we discuss the pricing of weather derivatives whose underlying weather variable is temperature. The dynamics of temperature in this study follows a two state regime switching model with a heteroskedastic mean reverting process as the base regime and a shifted regime defined by Brownian motion with nonzero drift. We develop mathematical formulas for pricing futures and option contracts on heating degree days (HDDs), cooling degree days (CDDs) and cumulative average temperature (CAT) indices. The local volatility nature of the model in the base regime captures very well the dynamics of the underlying process, thus leading to a better pricing processes for temperature derivatives contracts written on various index variables. We use the Monte Carlo simulation method for pricing weather derivatives call option contracts.

Keywords: Weather derivatives; arbitrage-free pricing; regime switching; Monte Carlo simulation; option pricing (search for similar items in EconPapers)
Date: 2018
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Persistent link: https://EconPapers.repec.org/RePEc:bpj:mcmeap:v:24:y:2018:i:1:p:13-27:n:2

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DOI: 10.1515/mcma-2018-0002

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