Universität Oslo
The volatility of temperature and pricing of weather derivatives
Abstract: We suggest a continuous-time autoregressive (CAR) model with a seasonally varying volatility as a model for the temperature dynamics, and apply this to price different derivatives written on temperature. The volatility has a very characteristic pattern over the season, and it turns out that an AR(3) model is explaining temperature reasonably well. We use a continuous version of this to analyze the forward price of contracts based on the HDD, CDD and CAT indices. Further we discuss the pricing and hedging of options written on these forward contracts. The talk is based on joint work with Jurate Saltyte Benth and Steen Koekebakker.