The volatility of temperature and pricing of weather derivatives |
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| Authors: | Fred ESPEN Benth Jūratė šaltytė Benth |
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| Affiliation: | 1. Centre of Mathematics for Applications , University of Oslo , P.O. Box 1053, Blindern, N-0316 Oslo, Norway fredb@math.uio.no;3. Centre of Mathematics for Applications , University of Oslo , P.O. Box 1053, Blindern, N-0316 Oslo, Norway |
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| Abstract: | We propose an Ornstein–Uhlenbeck process with seasonal volatility to model the time dynamics of daily average temperatures. The model is fitted to approximately 45 years of daily observations recorded in Stockholm, one of the European cities for which there is a trade in weather futures and options on the Chicago Mercantile Exchange. Explicit pricing dynamics for futures contracts written on the number of heating/cooling degree-days (so-called HDD/CDD futures) and the cumulative average daily temperature (so-called CAT futures) are calculated, along with a discussion on how to evaluate call and put options with these futures as underlying. |
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| Keywords: | Weather derivatives Temperature dynamics Stochastic processes Mean-reversion Seasonality Heating degree-day futures Options on temperature |
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