Pricing Financial Derivatives on Weather Sensitive Assets

Jerzy Filar, Boda Kang and Malgorzata Korolkiewicz
Additional contact information
Jerzy Filar: School of Mathematics and Statistics, University of South Australia
Malgorzata Korolkiewicz: School of Mathematics and Statistics, University of South Australia

No 223, Research Paper Series from Quantitative Finance Research Centre, University of Technology, Sydney

Abstract: We study pricing of derivatives when the underlying asset is sensitive to weather variables such as temperature, rainfall and others. We shall use temperature as a generic example of an important weather variable. In reality, such a variable would only account for a portion of the variability in the price of an asset. However, for the purpose of launching this line of investigations we shall assume that the asset price is a deterministic function of temperature and consider two functional forms: quadratic and exponential. We use the simplest mean-reverting process to model the temperature, the AR(1) time series model and its continuous-time counterpart the Ornstein-Uhlenbeck process. In continuous time, we use the replicating portfolio approach to obtain partial differential equations for a European call option price under both functional forms of the relationship between the weather-sensitive asset price and temperature. For the continuous-time model we also derive a binomial approximation, a finite difference method and a Monte Carlo simulation to numerically solve our option price PDE. In the discrete time model, we derive the distribution of the underlying asset and a formula for the value of a European call option under the physical probability measure.

Keywords: weather-sensitive asset; financial derivatives; diffusion; binomial approximation; numerical methods; time series; actuarial value (search for similar items in EconPapers)
Pages: 26 pages
Date: 2008-06-01
New Economics Papers: this item is included in nep-fmk
References: Add references at CitEc
Citations:

Downloads: (external link)
https://www.uts.edu.au/sites/default/files/qfr-archive-02/QFR-rp223.pdf (application/pdf)
Our link check indicates that this URL is bad, the error code is: 404 Not Found

Related works:
This item may be available elsewhere in EconPapers: Search for items with the same title.

Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text

Persistent link: https://EconPapers.repec.org/RePEc:uts:rpaper:223

Access Statistics for this paper

More papers in Research Paper Series from Quantitative Finance Research Centre, University of Technology, Sydney PO Box 123, Broadway, NSW 2007, Australia. Contact information at EDIRC.
Bibliographic data for series maintained by Duncan Ford ().