Pricing Weather Derivative: An Equilibrium Approach
Posted: 20 Sep 1999
Date Written: July, 1999
This paper proposes and implements an equilibrium framework for valuing weather derivatives. We generalize the Lucas model of 1978 to include the daily temperature as a fundamental variable in the economy. Temperature behavior in the past twenty years is closely studied for five major cities in the U.S., and a model is then proposed for the daily temperature variable which incorporates all the key properties of temperature behavior including seasonal cycles and uneven variations throughout the year. The model system is then estimated using the 20-year data and numerical analysis is subsequently performed for forward and option contracts on HDD's and CDD's. Key advantages of our model include the use of weather forecasts as inputs and the ability to handle contracts of any maturity, for any season. Numerical analysis shows that within our framework, the market price of risk associated with the temperature variable does not appear to impact the weather derivatives' value in a significant way, which implies it is indeed justifiable to use the riskfree rate to derive weather derivatives' values as many practitioners do in the industry. Finally, we show that the so-called historical simulation method can lead to significant pricing errors due to its erroneous implicit assumptions.
JEL Classification: G13
Suggested Citation: Suggested Citation