Derivative instruments written on non-tradable assets: The case of weather derivatives
In a wide variety of industries, from property management to natural gas retailing, firms face the possibility of significant earnings declines or advances because of unpredictable weather patterns. Weather derivatives offer an innovative hedging instrument to firms. Since 1997, weather derivatives have been written on several underlying variables including temperature, precipitation, snowfall, and windspeed in a myriad of forms including puts, calls, caps, floors, collars, and swaps. Weather derivatives promise to have a tremendous impact on the economy because they are the first derivative instruments that hedge volume. Therefore, profits are directly affected. In light of the enormous potential, the Chicago Mercantile Exchange launched the first exchange traded weather derivative on September 22, 1999. This paper addresses the fair value of these pioneering financial instruments. Valuing weather derivatives is substantially different from pricing other derivative instruments because the underlying stochastic process is not a tradable asset. This paper uses three pricing models: mean-reverting simulations, the Black-Scholes methodology, and ARMA simulations. Daily temperature data, from the cities of Boston and Atlanta, is used to estimate parameter values and perform the simulations. Finite difference equations are used to solve a modified Black-Scholes equation. These three models return similar results despite dramatically different modeling techniques.
Stewart, Robert Thomas, "Derivative instruments written on non-tradable assets: The case of weather derivatives" (2002). ETD Collection for Fordham University. AAI3045136.