The Use of Weather Forecasts in the Pricing of Weather Derivatives

34 Pages Posted: 26 Jun 2003

See all articles by Stephen Jewson

Stephen Jewson

Risk Management Solutions

Rodrigo Caballero

University of Chicago - Department of the Geophysical Sciences

Date Written: October 2002

Abstract

We discuss how weather forecasts can be used in the pricing of weather derivatives and derive results for the most important types of weather index and contract. We show that calculating the expected payoff of linear contracts on linear indices requires only forecasts of the mean temperature over the contract period. Calculating the expected payoff of linear contracts on non-linear indices requires forecasts of both the mean and the distribution of temperatures, but not of the dependence between temperature distributions on different days. Calculating the expected payoff of non-linear contracts requires forecasts of the full multivariate distribution of temperature over the whole contract. For contracts that extend beyond the end of the available forecasts, correlations between the forecast and the post-forecast periods must be taken into account when estimating this distribution. We present two methods by which this can be achieved, both of which combine information from climatological models of daily temperature with information from probabilistic forecasts.

Keywords: weather derivatives, weather risk, weather forecasts, ensemble forecasts, probabilistic forecasts

JEL Classification: G12, G13

Suggested Citation

Jewson, Stephen and Caballero, Rodrigo, The Use of Weather Forecasts in the Pricing of Weather Derivatives (October 2002). Available at SSRN: https://ssrn.com/abstract=405780 or http://dx.doi.org/10.2139/ssrn.405780

Stephen Jewson (Contact Author)

Risk Management Solutions ( email )

London EC3R 8NB
United Kingdom

Rodrigo Caballero

University of Chicago - Department of the Geophysical Sciences ( email )

5734 S. Ellis Avenue
Chicago, IL 60637
United States
001 773 702 9505 (Phone)

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