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The Implied Market Price of Weather Risk

Author

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  • Wolfgang Karl Härdle
  • Brenda López Cabrera

Abstract

Weather derivatives (WD) are end-products of a process known as securitization that transforms non-tradable risk factors (weather) into tradable financial assets. For pricing and hedging non-tradable assets, one essentially needs to incorporate the market price of risk (MPR), which is an important parameter of the associated equivalent martingale measure (EMM). The majority of papers so far has priced non-tradable assets assuming zero or constant MPR, but this assumption yields biased prices and has never been quantified earlier under the EMM framework. Given that liquid-derivative contracts based on daily temperature are traded on the Chicago Mercantile Exchange (CME), we infer the MPR from traded futures-type contracts (CAT, CDD, HDD and AAT). The results show how the MPR significantly differs from 0, how it varies in time and changes in sign. It can be parameterized, given its dependencies on time and temperature seasonal variation. We establish connections between the market risk premium (RP) and the MPR.

Suggested Citation

  • Wolfgang Karl Härdle & Brenda López Cabrera, 2012. "The Implied Market Price of Weather Risk," Applied Mathematical Finance, Taylor & Francis Journals, vol. 19(1), pages 59-95, February.
    • Handle: RePEc:taf:apmtfi:v:19:y:2012:i:1:p:59-95
    DOI: 10.1080/1350486X.2011.591170
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    References listed on IDEAS

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    More about this item

    JEL classification:

    • G19 - Financial Economics - - General Financial Markets - - - Other
    • G29 - Financial Economics - - Financial Institutions and Services - - - Other
    • N26 - Economic History - - Financial Markets and Institutions - - - Latin America; Caribbean
    • N56 - Economic History - - Agriculture, Natural Resources, Environment and Extractive Industries - - - Latin America; Caribbean
    • Q29 - Agricultural and Natural Resource Economics; Environmental and Ecological Economics - - Renewable Resources and Conservation - - - Other
    • Q54 - Agricultural and Natural Resource Economics; Environmental and Ecological Economics - - Environmental Economics - - - Climate; Natural Disasters and their Management; Global Warming

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