The Pricing of Temperature Futures at the Chicago Mercantile Exchange
28 Pages Posted: 9 Dec 2009 Last revised: 31 Mar 2011
Date Written: August 28, 2009
This paper analyzes observed prices of U.S. temperature futures at the Chicago Mercantile Exchange (CME). Results show that an index modeling approach without detrending captures the prices exceptionally well. Moreover, weather forecasts significantly influence prices up to 11 days ahead. It is shown that valuations of temperature futures relying on a model without detrending yield biased valuations by overpricing winter contracts and underpricing summer contracts. Several trading strategies are devised to exploit the mispricing observed at the CME and to demonstrate that speculating on temperature futures can not only generate high overall returns, but also perform well on a risk-adjusted basis.
Keywords: Weather derivatives, Index modeling, Weather forecast, Futures pricing, Trading strategy
JEL Classification: C53, G13, G29, Q54
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