Extracting Information from the Market to Price the Weather Derivatives

Abstract

Weather derivatives were first launched in 1996 in the United-States to allow companies to protect themselves against weather fluctuations. Even now their valuation still remains tricky. Because their underlying is not a traded asset, the weather options cannot be priced by using the Black and Scholes formula. Other pricing methods were proposed but they cannot be calibrated to the market since there are no available weather option price. However, quoted prices exist for the weather futures. The purpose of this paper is to extract two types of information from these prices, the risk-neutral distribution and the market price of risk, to value the weather derivatives. The prices are calculated by assuming that the daily average temperature obeys a mean-reverting jump-EGARCH process since it is shown that the temperature is not normally distributed and exhibits a time-varying volatility.

Keywords: weather derivatives, incomplete market, mean-reverting jump diffusion process, EGARCH process, PIDE, inversion problem

JEL Classification: G13, C63, C51