Pricing Basket Weather Derivatives on Rainfall and Temperature Processes

Nelson Christopher Dzupire, Philip Ngare and Leo Odongo
Additional contact information
Nelson Christopher Dzupire: Mathematics Department, Pan African University Institute of Basic Sciences, Technology, and Innovation, Juja, Nairobi 00200, Kenya
Philip Ngare: Mathematics Department, Pan African University Institute of Basic Sciences, Technology, and Innovation, Juja, Nairobi 00200, Kenya
Leo Odongo: Mathematics Department, Pan African University Institute of Basic Sciences, Technology, and Innovation, Juja, Nairobi 00200, Kenya

IJFS, 2019, vol. 7, issue 3, 1-14

Abstract: This paper follows an incomplete market pricing approach to analyze the evaluation of weather derivatives and the viability of a weather derivatives market in terms of hedging. A utility indifference method is developed for the specification of indifference prices for the seller and buyer of a basket of weather derivatives written on rainfall and temperature. The agent’s risk preference is described by an exponential utility function and the prices are derived by dynamic programming principles and corresponding Hamilton Jacobi-Bellman equations from the stochastic optimal control problems. It is found the indifference measure is equal to the physical measure as there is no correlation between the capital market and weather. The fair price of the derivative should be greater than the seller’s indifference price and less than the buyer’s indifference price for market viability and no arbitrage opportunities.

Keywords: incomplete market; basket option; indifference price; utility function; dynamic programming principle; Hamilton Jacobi-Bellman equations (search for similar items in EconPapers)
JEL-codes: F2 F3 F41 F42 G1 G2 G3 (search for similar items in EconPapers)
Date: 2019
References: View references in EconPapers View complete reference list from CitEc
Citations:

Downloads: (external link)
https://www.mdpi.com/2227-7072/7/3/35/pdf (application/pdf)
https://www.mdpi.com/2227-7072/7/3/35/ (text/html)

Related works:
This item may be available elsewhere in EconPapers: Search for items with the same title.

Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text

Persistent link: https://EconPapers.repec.org/RePEc:gam:jijfss:v:7:y:2019:i:3:p:35-:d:243312

Access Statistics for this article

IJFS is currently edited by Ms. Hannah Lu

More articles in IJFS from MDPI
Bibliographic data for series maintained by MDPI Indexing Manager ().