Estimating the payoffs of temperature-based weather derivatives

Clements, A.E., Hurn, A.S. and Lindsay, K.A. (2010) Estimating the payoffs of temperature-based weather derivatives. In: Gregoriou, G.N. and Pascalau, R. (eds.) Financial Econometrics Modeling: Derivatives Pricing, Hedge Funds and Term Structure Models. Palgrave Macmillan: Basingstoke, UK. ISBN 9780230283633

Abstract

Temperature-based weather derivatives are written on an index which is normally defined to be a nonlinear function of average daily temperatures. Recent empirical work has demonstrated the usefulness of simple time-series models of temperature for estimating the payoffs to these instruments. This paper argues that a more direct and parsimonious approach is to model the time-series behaviour of the index itself, provided a sufficiently rich supply of historical data is available. A data set comprising average daily temperature spanning over a hundred years for four Australian cities is assembled. The data is then used to compare the actual payoffs of temperature-based European call options with the expected payoffs computed from historical temperature records and two time-series approaches. It is concluded that expected payoffs computed directly from historical records perform poorly by comparison with the expected payoffs generated by means of competing time-series models. It is also found that modeling the relevant temperature index directly is superior to modeling average daily temperatures.

• Item Type: Book Sections
• Status: Published
• Refereed: Yes
• Glasgow Author(s) Enlighten ID: Lindsay, Professor Kenneth
• Authors: Clements, A.E., Hurn, A.S., and Lindsay, K.A.
• Subjects: Q Science > QA Mathematics
• College/School: College of Science and Engineering > School of Mathematics and Statistics > Mathematics
• Publisher: Palgrave Macmillan
• ISBN: 9780230283633