Valuation and hedging of weather derivatives on monthly average temperature

ABSTRACT In this paper, we develop two types of pricing approach, one based on the utility indifference valuation and the other on non-parametric trend prediction, and estimate their hedge effect on energy businesses using empirical data. First, we consider an over-the-counter market for weather derivatives between an insurance company and an industry that runs a project affected by a weather index, for example, average temperature. We demonstrate supply and demand lines corresponding to those two positions, derive the equilibrium price and volume based on the exponential utility function and then generalize the result for a multi-period case so that swap contracts are carried out in continuous-time settings. Next, we introduce a trend-prediction-based pricing technique and analyze the hedge effect of weather derivatives on energy businesses. The historical simulation shows that the future contracts are highly effective for hedging electricity revenue when the revenue is proportional to the electricity sales in summer. Moreover, we demonstrate an optimal revenue structure with respect to the electricity sales when put options are used.