A Fair Pricing Approach to Weather Derivatives |
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| Authors: | Eckhard?Platen Email author" target="_blank">Jason?WestEmail author |
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| Institution: | (1) School of Finance and Economics and Department of Mathematical Sciences, Sydney, P.O. Box 123, Broadway, NSW 2007, Australia;(2) School of Finance and Economics, University of Technology, Sydney, P.O. Box 123, Broadway, NSW 2007, Australia |
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| Abstract: | This paper proposes a consistent approach to the pricing of weather derivatives. Since weather derivatives are traded in an
incomplete market setting, standard hedging based pricing methods cannot be applied. The growth optimal portfolio, which is
interpreted as a world stock index, is used as a benchmark or numeraire such that all benchmarked derivative price processes
are martingales. No measure transformation is needed for the proposed fair pricing. For weather derivative payoffs that are
independent of the value of the growth optimal portfolio, it is shown that the classical actuarial pricing methodology is
a particular case of the fair pricing concept. A discrete time model is constructed to approximate historical weather characteristics.
The fair prices of some particular weather derivatives are derived using historical and Gaussian residuals. The question of
weather risk as diversifiable risk is also discussed.
1991 Mathematics Subject Classification: primary 90A12; secondary 60G30; 62P20
JEL Classification: C16, G10, G13 |
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| Keywords: | actuarial pricing benchmark approach fair pricing growth optimal portfolio weather derivatives |
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