Pricing of Asian Temperature Risk

SFB 649 Discussion Paper 2009-046

34 Pages Posted: 11 Dec 2017

See all articles by Fred Espen Benth

Fred Espen Benth

University of Oslo

Wolfgang K. Härdle

Humboldt University of Berlin - Institute for Statistics and Econometrics; Humboldt University of Berlin - Center for Applied Statistics and Economics (CASE)

Brenda López Cabrera

Humboldt University of Berlin

Date Written: October 9, 2009

Abstract

Weather derivatives (WD) are different from most financial derivatives because the underlying weather cannot be traded and therefore cannot be replicated by other financial instruments. The market price of risk (MPR) is an important parameter of the associated equivalent martingale measures used to price and hedge weather futures/options in the market. The majority of papers so far have priced non-tradable assets assuming zero MPR, but this assumption underestimates WD prices. We study the MPR structure as a time dependent object with concentration on emerging markets in Asia. We find that Asian Temperatures (Tokyo, Osaka, Beijing, Teipei) are normal in the sense that the driving stochastics are close to a Wiener Process. The regression residuals of the temperature show a clear seasonal variation and the volatility term structure of CAT temperature futures presents a modified Samuelson effect. In order to achieve normality in standardized residuals, the seasonal variation is calibrated with a combination of a fourier truncated series with a GARCH model and with a local linear regression. By calibrating model prices, we implied the MPR from Cumulative total of 24- hour average temperature futures (C24AT) for Japanese Cities, or by knowing the formal dependence of MPR on seasonal variation, we price derivatives for Kaohsiung, where weather derivative market does not exist. The findings support theoretical results of reverse relation between MPR and seasonal variation of temperature process.

Keywords: Weather Derivatives, Continuous Autoregressive Model, CAT, CDD, HDD, Risk Premium

JEL Classification: G19, G29, G22, N23, N53, Q59

Suggested Citation

Benth, Fred Espen and Härdle, Wolfgang K. and Cabrera, Brenda López, Pricing of Asian Temperature Risk (October 9, 2009). SFB 649 Discussion Paper 2009-046. Available at SSRN: https://ssrn.com/abstract=2894247 or http://dx.doi.org/10.2139/ssrn.2894247

Fred Espen Benth

University of Oslo ( email )

Center of Mathematics for Applications
Oslo, N-0317
Norway

Wolfgang K. Härdle (Contact Author)

Humboldt University of Berlin - Institute for Statistics and Econometrics ( email )

Unter den Linden 6
Berlin, D-10099
Germany
+49 30 2093 5631 (Phone)
+49 30 2093 5649 (Fax)

Humboldt University of Berlin - Center for Applied Statistics and Economics (CASE)

Unter den Linden 6
Berlin, D-10099
Germany

Brenda López Cabrera

Humboldt University of Berlin

Unter den Linden 6
Berlin, AK Berlin 10099
Germany

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