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Pricing Basket Weather Derivatives on Rainfall and Temperature Processes

Author

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  • Nelson Christopher Dzupire

    (Mathematics Department, Pan African University Institute of Basic Sciences, Technology, and Innovation, Juja, Nairobi 00200, Kenya)

  • Philip Ngare

    (Mathematics Department, Pan African University Institute of Basic Sciences, Technology, and Innovation, Juja, Nairobi 00200, Kenya
    Department Actuarial Science, University of Nairobi, Nairobi 00100, Kenya)

  • Leo Odongo

    (Mathematics Department, Pan African University Institute of Basic Sciences, Technology, and Innovation, Juja, Nairobi 00200, Kenya
    Department of Statistics and Actuarial Science, Kenyatta University, Nairobi 00100, Kenya)

Abstract

This paper follows an incomplete market pricing approach to analyze the evaluation of weather derivatives and the viability of a weather derivatives market in terms of hedging. A utility indifference method is developed for the specification of indifference prices for the seller and buyer of a basket of weather derivatives written on rainfall and temperature. The agent’s risk preference is described by an exponential utility function and the prices are derived by dynamic programming principles and corresponding Hamilton Jacobi-Bellman equations from the stochastic optimal control problems. It is found the indifference measure is equal to the physical measure as there is no correlation between the capital market and weather. The fair price of the derivative should be greater than the seller’s indifference price and less than the buyer’s indifference price for market viability and no arbitrage opportunities.

Suggested Citation

  • Nelson Christopher Dzupire & Philip Ngare & Leo Odongo, 2019. "Pricing Basket Weather Derivatives on Rainfall and Temperature Processes," IJFS, MDPI, vol. 7(3), pages 1-14, June.
    • Handle: RePEc:gam:jijfss:v:7:y:2019:i:3:p:35-:d:243312
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    References listed on IDEAS

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