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Pricing Temperature Derivatives Under Weather Forecasts

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  • MARKUS HESS

Abstract

We investigate the pricing of temperature derivatives under weather forecasts modeled by initially enlarged filtrations. For this purpose, we introduce a mean-reverting temperature model with seasonality and derive expressions for the so-called forward temperature. Although our analysis focuses on cumulative average temperature (CAT) futures, the presented derivation techniques can likewise be applied to other weather derivatives such as heating degree day (HDD) or cooling degree day (CDD) futures, for instance. We also treat option pricing and utility maximizing portfolio selection in temperature markets under additional information on future weather behavior. We finally prove an anticipative sufficient stochastic minimum principle in an enlarged filtration setup and apply the result to minimal variance hedging of temperature derivatives under weather forecasts. In this context, we derive explicit minimal variance hedging portfolios for different weather-related claims.

Suggested Citation

  • Markus Hess, 2018. "Pricing Temperature Derivatives Under Weather Forecasts," International Journal of Theoretical and Applied Finance (IJTAF), World Scientific Publishing Co. Pte. Ltd., vol. 21(05), pages 1-34, August.
    • Handle: RePEc:wsi:ijtafx:v:21:y:2018:i:05:n:s0219024918500310
    DOI: 10.1142/S0219024918500310
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    References listed on IDEAS

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    1. Fred Espen Benth & Jurate Saltyte-Benth, 2005. "Stochastic Modelling of Temperature Variations with a View Towards Weather Derivatives," Applied Mathematical Finance, Taylor & Francis Journals, vol. 12(1), pages 53-85.
    2. Dorfleitner, Gregor & Wimmer, Maximilian, 2010. "The pricing of temperature futures at the Chicago Mercantile Exchange," Journal of Banking & Finance, Elsevier, vol. 34(6), pages 1360-1370, June.
    3. Fred ESPEN Benth & Jurate saltyte Benth, 2007. "The volatility of temperature and pricing of weather derivatives," Quantitative Finance, Taylor & Francis Journals, vol. 7(5), pages 553-561.
    4. Andrea Barth & Fred Espen Benth & Jurgen Potthoff, 2011. "Hedging of Spatial Temperature Risk with Market-Traded Futures," Applied Mathematical Finance, Taylor & Francis Journals, vol. 18(2), pages 93-117.
    5. Markus Hess, 2016. "Modeling and pricing precipitation derivatives under weather forecasts," ULB Institutional Repository 2013/247729, ULB -- Universite Libre de Bruxelles.
    6. Francesca Biagini & Bernt Øksendal, 2006. "Minimal Variance Hedging For Insider Trading," International Journal of Theoretical and Applied Finance (IJTAF), World Scientific Publishing Co. Pte. Ltd., vol. 9(08), pages 1351-1375.
    7. Philipp Hell & Thilo Meyer-Brandis & Thorsten Rheinländer, 2012. "Consistent Factor Models For Temperature Markets," International Journal of Theoretical and Applied Finance (IJTAF), World Scientific Publishing Co. Pte. Ltd., vol. 15(04), pages 1-24.
    8. Giulia Di Nunno & Thilo Meyer-Brandis & Bernt Øksendal & Frank Proske, 2006. "Optimal portfolio for an insider in a market driven by Levy processes," Quantitative Finance, Taylor & Francis Journals, vol. 6(1), pages 83-94.
    9. Peter Alaton & Boualem Djehiche & David Stillberger, 2002. "On modelling and pricing weather derivatives," Applied Mathematical Finance, Taylor & Francis Journals, vol. 9(1), pages 1-20.
    10. Markus Hess, 2016. "Modeling And Pricing Precipitation Derivatives Under Weather Forecasts," International Journal of Theoretical and Applied Finance (IJTAF), World Scientific Publishing Co. Pte. Ltd., vol. 19(07), pages 1-29, November.
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    Cited by:

    1. Simona Franzoni & Cristian Pelizzari, 2021. "Rainfall option impact on profits of the hospitality industry through scenario correlation and copulas," Annals of Operations Research, Springer, vol. 299(1), pages 939-962, April.
    2. Markus Hess, 2019. "Optimal Equivalent Probability Measures under Enlarged Filtrations," Journal of Optimization Theory and Applications, Springer, vol. 183(3), pages 813-839, December.
    3. Markus Hess, 2021. "A new approach to wind power futures pricing," Decisions in Economics and Finance, Springer;Associazione per la Matematica, vol. 44(2), pages 1235-1252, December.

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