State price densities implied from weather derivatives

Wolfgang Härdle, Brenda López-Cabrera and Huei-Wen Teng
Authors registered in the RePEc Author Service: Brenda López-Cabrera

Insurance: Mathematics and Economics, 2015, vol. 64, issue C, 106-125

Abstract: A State Price Density (SPD) is the density function of a risk neutral equivalent martingale measure for option pricing, and is indispensable for exotic option pricing and portfolio risk management. Many approaches have been proposed in the last two decades to calibrate a SPD using financial options from the bond and equity markets. Among these, non and semiparametric methods were preferred because they can avoid model mis-specification of the underlying. However, these methods usually require a large data set to achieve desired convergence properties. One faces the problem in estimation by e.g., kernel techniques that there are not enough observations locally available. For this situation, we employ a Bayesian quadrature method because it allows us to incorporate prior assumptions on the model parameters and hence avoids problems with data sparsity. It is able to compute the SPD of both call and put options simultaneously, and is particularly robust when the market faces the data sparsity issue. As illustration, we calibrate the SPD for weather derivatives, a classical example of incomplete markets with financial contracts payoffs linked to non-tradable assets, namely, weather indices. Finally, we study related weather derivatives data and the dynamics of the implied SPDs.

Keywords: Weather derivatives; Temperature derivatives; HDD; CDD; State Price Density; Quadrature; Bayesian; Data sparsity (search for similar items in EconPapers)
Date: 2015
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (2)

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Working Paper: State Price Densities implied from weather derivatives (2013)
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Persistent link: https://EconPapers.repec.org/RePEc:eee:insuma:v:64:y:2015:i:c:p:106-125

DOI: 10.1016/j.insmatheco.2015.05.001

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