University of Newcastle upon Tyne

School of Mathematics and Statistics

Statistics Seminars 2004-2005

5 November 2004, L401, 2:15pm

Dr Michalis Zervos, Financial Mathematics Research Group, King's College, London

Abstract

We consider the problem of pricing weather derivatives based on linear temperature indices. Anticipating the development of a liquid weather swap market, we address the issue of pricing weather derivative options using weather swaps as hedging instruments. Our analysis starts by considering stochastic dynamics that are appropriate for the modelling of actively traded swaps, which is an issue that involves weather forecast considerations. It then proceeds to an adaptation of the continuous-time mathematical finance theory that ensures the absence of arbitrage opportunities within the weather derivative market, and provides formulae for the rational prices of weather derivative options. The results derived include the modifications of the Black and Scholes and Black formulae that are appropriate for weather derivative pricing.

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