A fair pricing approach to weather derivatives

Publication Type:
Journal Article
Asia-Pacific Financial Markets, 2005, 11 (1), pp. 23 - 53
Issue Date:
Full metadata record
Files in This Item:
Filename Description SizeFormat
2005001976.pdf367.03 kBAdobe PDF
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 paricing. 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 concepts. A discrete time model is constructed to approximate historical weather characteristics. The fair prices of some partuclar weather derivatives are derived using historical and Gaussian residuals. The question of weather risk as diversifiable risk is also discussed.
Please use this identifier to cite or link to this item: