PRICING PRECIPITATION BASED DERIVATIVES

René Carmona () and Pavel Diko ()
Additional contact information
René Carmona: Department of Operations Research and Financial Engineering, Princeton University, Princeton, NJ 08544, USA;
Pavel Diko: Electrabel S.A., Trading & Portfolio Management, Boulevard du Régent 8, Bruxelles 1000, Belgium

International Journal of Theoretical and Applied Finance (IJTAF), 2005, vol. 08, issue 07, 959-988

Abstract: We consider the problem of pricing a derivative contract written on precipitation at a specific location during a given period of time. We propose a jump Markov process model for the stochastic dynamics of the underlying precipitation. Our model is based on pulse Poisson process models widely used in hydrology. We develop maximum likelihood parameter estimation procedures to fit our model to rainfall data. In order to price derivatives, we assume the existence of a traded asset whose price dynamics are influenced by the precipitation at the location in question, and we rely on the utility indifference approach. Two utility functions are considered: exponential and power utility. We derive explicit solutions for the exponential and bounds for the power utility.Finally, we apply our model fitting and pricing techniques to a sample rainfall contract in Norway.

Keywords: Weather derivatives; utility indifference pricing; precipitation modeling; jump Markov processes; maximum likelihood estimation (search for similar items in EconPapers)
Date: 2005
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (11)

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DOI: 10.1142/S0219024905003311

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