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Weather derivatives pricing using regime switching model

Author

Listed:
  • Evarest Emmanuel

    (Department of Mathematics, Linköping University, 581 83 Linköping, Sweden; and Department of Mathematics, University of Dar Es Salaam, P.O. Box 35062, Dar Es Salaam, Tanzania)

  • Berntsson Fredrik

    (Department of Mathematics, Linköping University, 581 83 Linköping, Sweden)

  • Singull Martin

    (Department of Mathematics, Linköping University, 581 83 Linköping, Sweden)

  • Yang Xiangfeng

    (Department of Mathematics, Linköping University, 581 83 Linköping, Sweden)

Abstract

In this study we discuss the pricing of weather derivatives whose underlying weather variable is temperature. The dynamics of temperature in this study follows a two state regime switching model with a heteroskedastic mean reverting process as the base regime and a shifted regime defined by Brownian motion with nonzero drift. We develop mathematical formulas for pricing futures and option contracts on heating degree days (HDDs), cooling degree days (CDDs) and cumulative average temperature (CAT) indices. The local volatility nature of the model in the base regime captures very well the dynamics of the underlying process, thus leading to a better pricing processes for temperature derivatives contracts written on various index variables. We use the Monte Carlo simulation method for pricing weather derivatives call option contracts.

Suggested Citation

  • Evarest Emmanuel & Berntsson Fredrik & Singull Martin & Yang Xiangfeng, 2018. "Weather derivatives pricing using regime switching model," Monte Carlo Methods and Applications, De Gruyter, vol. 24(1), pages 13-27, March.
    • Handle: RePEc:bpj:mcmeap:v:24:y:2018:i:1:p:13-27:n:2
    DOI: 10.1515/mcma-2018-0002
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    References listed on IDEAS

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