Asia-Pacific Financial Markets

, Volume 11, Issue 1, pp 23–53

A Fair Pricing Approach to Weather Derivatives

Article

Abstract

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 pricing. 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 concept. A discrete time model is constructed to approximate historical weather characteristics. The fair prices of some particular weather derivatives are derived using historical and Gaussian residuals. The question of weather risk as diversifiable risk is also discussed.

Key Words

actuarial pricing benchmark approach fair pricing growth optimal portfolio weather derivatives 

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Copyright information

© Springer Science + Business Media, Inc. 2005

Authors and Affiliations

  1. 1.School of Finance and Economics and Department of Mathematical SciencesSydneyBroadwayAustralia
  2. 2.School of Finance and EconomicsUniversity of TechnologySydneyBroadwayAustralia

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