4.1

Pricing a financial instrument to guarantee the accuracy of a weather forecast

Harvey Stern, Bureau of Meteorology, Melbourne, Victoria, Australia; and S. Dawkins

Customers receiving weather forecasts have become increasingly interested in the quality of the service provided. This reflects an overall trend in business towards implementing risk management strategies. These strategies include managing weather related risk. Indeed, the US Company Aquila has a web site that presents several illustrations of the concept: http://www.guaranteedweather.com

The guarantee is that the forecast will be in error by no more than 3°C. The terms of the guarantee are that the seller of the guarantee will pay the buyer $100.00 for each 0.1°C greater than 3°C that the forecast is in error. The purpose of the paper is to develop an approach to pricing such a financial guarantee, and to provide it as a technique that is available on the web.

The instrument is made up of a combination of a call option and a put option about the next day's maximum temperature at Melbourne, the "strikes" being set respectively 3°C above and below the forecast temperature. The taker of this option combination receives $100 for each 0.1°C that the observed temperature is above or below the respective strikes.

The approach used is as follows:

• The forecast verification data is stratified according to month, and also according to the nature of the prevailing atmospheric circulation - cyclonicity, direction and strength of the surface flow.
• The distribution of the magnitude of forecast errors for each month (and also for each synoptic pattern type) is noted.
• This distribution is adjusted in order to take into account a long-term downward trend in the magnitude of the errors;
• The distribution of forecast errors is assumed to be normal for each data subset, and a "fair value" price for the option combination for each month and each circulation type is then obtained.

A web site is developed in order that:

• potential "customers" may readily obtain a price for the instrument; and,
• researchers may test its output.

This may be viewed and tested at: http://www.weather-climate.com/guarantee.html

It was considered that if, over a large number of cases, writers of the option combination not make either a significant profit or a significant loss, the validity of the "fair value" price would be demonstrated.

The instrument's validity was then tested by calculating the "fair value" price on independent cases taken for the entire year of 2001.

However, from an analysis of all of the year 2001 cases, it was determined that writers of the option combination would have received $75,574 over the year, while paying out only $23,800.

Nevertheless, this substantial profit (over 200% return) is not necessarily suggesting a possible flaw in the valuation technique. On the contrary, it may be explained in terms of the spectacular improvement in the accuracy of forecasts achieved during 2001. Had the forecasts been of similar skill to those of previous years, the payout would have been much closer to the monies received. The profit achieved by the option writers can, therefore, be explained in terms of that increased skill.

  Extended Abstract (148K)

Supplementary URL: http://www.weather-climate.com/guarantee.html

Session 4, All aspects of artificial intelligence applications to environmental sciences
Tuesday, 11 February 2003, 2:15 PM-5:15 PM

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