Hot or Cold?: A Comparison of Different Approaches to the Pricing of Weather Derivatives

Journal of Emerging Markets Finance, Forthcoming

Posted: 11 Jul 2004

See all articles by Teddy Oetomo

Teddy Oetomo

Schroder Investment Management Indonesia

Maxwell Stevenson

University of Sydney - School of Business - Finance Discipline; Financial Research Network (FIRN)

Abstract

The article reviews six different temperature forecasting models propsoed by the prior literature for pricing weather derivatives. Simulation of these models is used to estimate daily temperature and, as a consequence, the metrics used for pricing temperature derivatives. The models that rely on an Autoregressive Moving Average (ARMA) process exhibit a better goodness-of-fit than those that are established under Monte Carlo simulations. However, the superiority of ARMA-type models is not reflected over the forecast horizon. Over that period, the models which rely on Monte Carlo simulations exhibit a tendency to over-forecast the monthly accumulated Heating Degree Day (AccHDD) index and to under-forecast the monthly-accumulated Cooling Degree Day (AccCDD) index. Alternatively, models established under the ARMA approach both under-forecast and over-forecast the monthly accumulated indices. All models consistently over-forecast the average daily temperature. The most appropriate pricing model varies between cities and months. Finally, the models examined in this study generate a more accurate AccHDD futures price than the traded price on the market. However, the ability of these models to estimate the AccCDD futures price is significantly poorer than that of the market.

JEL Classification: C52, G13, Q40

Suggested Citation

Oetomo, Teddy and Stevenson, Max, Hot or Cold?: A Comparison of Different Approaches to the Pricing of Weather Derivatives. Journal of Emerging Markets Finance, Forthcoming, Available at SSRN: https://ssrn.com/abstract=563102

Teddy Oetomo (Contact Author)

Schroder Investment Management Indonesia ( email )

31 Gresham Street
London, EC2V 7QA
United Kingdom

Max Stevenson

University of Sydney - School of Business - Finance Discipline ( email )

P.O. Box H58
Sydney, NSW 2006
Australia

Financial Research Network (FIRN)

C/- University of Queensland Business School
St Lucia, 4071 Brisbane
Queensland
Australia

HOME PAGE: http://www.firn.org.au

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