13th Conference on Applied Climatology and the 10th Conference on Aviation, Range, and Aerospace Meteorology

Wednesday, 15 May 2002: 4:15 PM
An Objective tool for pricing degree day weather options
Douglas A. Stewart, Environmental Dynamics Research, Inc., Lantana, FL
The weather derivatives market has been slowly growing since 1997, and has recently expanded into Europe and Japan. Early expectation of explosive growth within the industry has been hindered by a lack of end-user participation. One reason is that end users, who would typically buy weather derivatives, are not sure that the value quoted by the seller is fair, and are reluctant to devote resources to developing their own valuation methods. There are few tools available to independently and objectively price weather derivatives.

Objectively pricing the standard call and put degree-day options, and combinations of the two, is primarily dependent on the projected probability distribution of the daily average temperature over the period of the option. While historical probability distributions are often used, better projections are possible using official and experimental forecasts produced by state-of-the-art research and development at the U.S. National Centers for Environmental Prediction.

A system is described that allows pricing single or simple combination options for over 180 U.S. locations at any time before or during the option period, which can range from one month to one year. The system is driven by daily analysis and MOS-adjusted MRF forecast temperatures as well monthly long-lead forecast temperature probabilities, all available from the U.S. Climate Prediction Center. Stochastic temperature generators are used for near-term daily projections and for extended range monthly mean projections. The system is web-based, updated daily, and available on a subscription basis for a nominal fee.

Also described is a new system for projecting temperatures within the 0-2 month time frame. This system incorporates ensemble forecasts and model bias adjustments in addition to analysis and MRF forecast data. This system is currently being finalized and will ultimately be integrated into the web-based option pricing tools.

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