Pricing of Temperature-based Weather Contracts forTurkey
A. Goncu, M. O. Karahan, and T. U. Kuzubas,
Czech Journal of Finance and Economics (under review)
Submitted onNovember 26th, 2010
Abstract
Weather derivatives provide better risk management alternatives for industries which are exposed to the weather-based risks. Dynamic pricing of weather derivatives requires a suitable underlying temperature model. This paper is the first to model the average daily temperatures and prices of heating/cooling degree days (HDD/CDD) option contracts forIstanbul,Turkey. We model daily average temperatures using the mean-reverting Ornstein-Uhlenbeck (OU) process both with constant and time-varying mean reversion parameters.HDD/CDD options forIstanbulare priced using analytical approximation andMonte Carlosimulations. In most cases estimates are lower when time-varying mean reversion model is used. We discuss several issues on the importance of weather derivatives markets for developing countries.
