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Dynamical pricing of weather derivatives

Author

Listed:
  • Dorje Brody
  • Joanna Syroka
  • Mihail Zervos

Abstract

The dynamics of temperature can be modelled by means of a stochastic process known as fractional Brownian motion. Based on this empirical observation, we characterize temperature dynamics by a fractional Ornstein-Uhlenbeck process. This model is used to price two types of contingent claims: one based on heating and cooling degree days, and one based on cumulative temperature. We derive analytic expressions for the expected discounted payoffs of such derivatives, and discuss the dependence of the results on the fractionality of the temperature dynamics.

Suggested Citation

  • Dorje Brody & Joanna Syroka & Mihail Zervos, 2002. "Dynamical pricing of weather derivatives," Quantitative Finance, Taylor & Francis Journals, vol. 2(3), pages 189-198.
    • Handle: RePEc:taf:quantf:v:2:y:2002:i:3:p:189-198
    DOI: 10.1088/1469-7688/2/3/302
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    References listed on IDEAS

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    1. L. C. G. Rogers, 1997. "Arbitrage with Fractional Brownian Motion," Mathematical Finance, Wiley Blackwell, vol. 7(1), pages 95-105, January.
    2. M. Davis, 2001. "Pricing weather derivatives by marginal value," Quantitative Finance, Taylor & Francis Journals, vol. 1(3), pages 305-308, March.
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