Pricing temperature-based weather derivatives inChina

A. Goncu

Abstract

Weather derivatives facilitate better risk management in many weather-affected industries. With its diverse geography,Chinacould reap important gains by developing a weather derivatives market. This study proposes a feasible model for the daily average temperatures ofBeijing,Shanghaiand Shenzhen in order to price temperature-based weather derivatives. It uses a seasonal volatility model that estimates daily average temperatures using the mean-reverting or Ornstein-Uhlenbeck process. It then uses the analytical approximation andMonte Carlomethods to price heating degree days and cooling degree days options for these cities. In addition, it derives and calculates option sensitivities on the basis of an analytical approximation formula.