Weather Derivative
Weather Derivative
Weather Derivative
Weather Derivative
Modelling and Valuation:
A Statistical Perspective
Anders Brix, Stephen Jewson and Christine Ziehmann
Risk Management Solutions
Introduction
Weather derivatives are different from most other derivatives in that the underlying
weather cannot be traded. Furthermore, the weather derivatives market is relatively
illiquid. This means that weather derivatives cannot be cost-efficiently replicated with
other weather derivatives, ie, for most locations the bid–ask spread is too large to
make it economical to hedge a position. One of the consequences of this is that
valuation of weather derivatives is closer to insurance pricing than to derivatives
pricing (arbitrage pricing). For this reason it is important to base valuation on
reliable historical data, and to be able to model the underlying indexes accurately.
In the future, the weather derivatives market may become more liquid, and at that
point it may be possible to use other weather derivatives for hedging and thereby
derive prices from the market for at least some contracts. However, the main purpose
of this chapter is to review how weather derivatives are priced using historical data,
and to highlight some of the challenges that arise when doing so. The presentation
is statistical in its focus on the choice of models and model validation.
Before discussing the topics of detrending (removing trends from a time-series),
index and daily temperature modelling, portfolio modelling and risk loading (the
risk premuim added to the expected payoff in order to compensate the risk bearer
for taking on risk), this chapter begins with with a discussion of the relationship
between index and payoff distributions, which will be useful in the later sections.
Throughout the chapter the methods described will be illustrated with a relatively
commonly traded contract: a New York LaGuardia, May 1–September 30 cooling
degree-day (CDD) call option. Because more than 90% of the weather derivatives
currently traded are based on temperature (WRMA, 2002), the main focus of this
chapter will be on models for such indexes. Most of the index-based methods
0 I≤S
= d(I – S) S<I≤L
d(L – S) I>L
Using the tick we can convert the limit, L, into a USdollar limit L$ = d (L–S), and the
CDF G of the payoff can be expressed as:
F (S) P=0
G (P) =
F S+
P
d 0 < P ≤ L$ (2)
1 P > L$
Because of the strike and limit, the payoff P is partly discrete with point masses at
zero and the limit L$. Between these two points the distribution is discrete or
continuous depending on whether the underlying index distribution is discrete or
continuous.
The mean of the payoff can be conveniently calculated using the limited expected
1
value (LEV) LI for the index I :
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LI (m) = E min(I, m) W E AT H E R D E R I VAT I V E
m MODELLING AND
= ∫–∞
I dF (I ) + m (1 – F (m))
VA L U AT I O N : A
Here, m is the arguement of LI and it is seen that if we let m tend to infinity, LI (m) S TAT I S T I C A L
tends to the expected value of I. Taking the expectation of Equation (1) and using
PERSPECTIVE
the definition of LI (m), we see that the mean payoff is given by:
This expression shows that the LEV function is one of the fundamentally relevant
properties of the index distribution when pricing weather derivative options. If other
moments of the payoff distribution are of interest, they can be calculated using
k
higher-order LEV functions such as E min(m, I ) .
The formulae for calculating payoff distributions and LEV functions are illustrated
with some commonly used distributions in examples 1–3 in Panel 1.
1. The global average surface temperature has increased by 0.6 (+/– 0.2) degrees
Celsius since the late 19th century (IPCC, 2001).
2. Trends depend on the period chosen. For the US, for example, the temperature
history since 1910 can be divided into three periods: a warming period until 1940,
a cooling period from 1940 to 1970, and the recent warming period from 1970 to
the present (Knappenberger et al., 2001).
3. Trends depend on location. The recent period of warming has been almost global,
but the largest increases of temperature have occurred over the mid- and high
latitudes of continents in the northern hemisphere. Year-round cooling is only
evident in the northwestern North Atlantic and the central North Pacific Oceans
(although the North Atlantic cooling appears to have reversed recently, see for
example Hansen et al., 1996 and IPCC, 2001).
4. Trends for maximum and minimum temperatures are different. The diurnal range,
the difference between daily maximum and daily minimum temperatures, is
decreasing, although not everywhere. On average, minimum temperatures are
increasing at about twice the rate of maximum temperatures (see for example
Easterling et al., 1997 and IPCC, 2001).
5. A recent study of Knappenberger et al. (2001) shows that the trends are not
uniform; cool days are much warmer than they used to be, whereas warm days are
not.
log S – µ
Φ P=0
σ
G(P) = Φ log (S + P / d) – µ
σ 0 < P ≤ L$
1 P > L$
2
σ log m – µ
LI (m) = exp µ + Φ – σ + m (1 – G(m))
2 σ
2
σ log L – µ log S – µ
E P = d exp µ + Φ –σ –Φ –σ
2 σ σ
+ dL (1 – G (L)) – dS (1 – G (S))
Example 2
2
If the index follows a normal distribution, with mean µ and variance σ , the situation
is a bit more complicated because the limited expected moments are less tractable.
The payoff CDF is simple:
S–µ
Φ P=0
σ
G(P) = Φ S+P/d–µ
σ 0 < P ≤ L$
1 P > L$
m
∫
u 1 2
L0, 1(m) = exp – u du
–∞
2π 2
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W E AT H E R D E R I VAT I V E
Example 3
The general formulae above apply equally well when the underlying index follows a MODELLING AND
discrete distribution. Consider the case where I follows a negative binomial VA L U AT I O N : A
distribution. Although it is easy to calculate numerically, there is no closed-form
expression for the CDF of this distribution. In the following we will denote the CDF of
S TAT I S T I C A L
2
the negative binomial with mean r (1 – p)/p and variance r (1 – p)/p by Fr,p . The PERSPECTIVE
payoff CDF is given by Equation (2) with F replaced by Fr,p and the LEV function is
given by:
rp
Lr, p (m) = Fr+1, p (m) + m (1 – Fr, p(m))
1–p
can only be made if the two stations are in the same microclimate region. As an
example, this chapter will compare the CDD index for New York LaGuardia Airport
with the corresponding index for Central Park, New York. These two stations are in
the vicinity of each other, but whereas much has been built in the LaGuardia area
over the last 30–40 years and it is at the water’s edge, not much has changed
structurally over the same period around Central Park, in the heart of the New York
City. Figure 1 shows the historical CDD indexes for the two locations with linear
trends overlaid. Visually, the difference between the two plots is striking, and t-tests
of the significance of the slopes of the trendline reveal that the Central Park trend is
not significant (p=34%), while the LaGuardia trend is highly significant (p=0.06%).
For the purposes of this chapter, it is not important to distinguish between local
and global trends because we are interested in removing the combined trend. There
are many models in the statistical literature for estimating distributions with trends.
The way the trend is incorporated is often linear or multiplicative in the mean (for
example, an index is typically modelled as trend plus noise for a normal distribution,
and trend multiplied by noise for a log-normal distribution), and is usually chosen
on the basis of mathematical convenience rather than reflecting reality (since it can
be difficult to find a ‘realistic’ model for many applications and since the
appropriateness of the model must be validated anyway). This section separates
trend estimation from distribution estimation on the basis that this simplifies the
calculations, and because we can then treat all distributions in the same way.
1. Historical indexes for New York LaGuardia Airport (left) and Central Park, New
York (right). Linear trends have been superimposed.
INDEX DETRENDING
The assumption of the trend model used here is that an index Ii can be represented
as a sum of a trend Ri and a random variable ei :
ei are assumed to be independent and identically distributed with mean zero. The
~
detrended indexes, Ii , are then defined as
~
Ii = Ii – R̂ + R̂n (3)
where R̂and R̂n are the estimated trends for indexes i and n.
In this way, the mean of all indexes are shifted to the estimated mean of the last
index. Often the contract will commence a year (or more) after of the end of the
historical indexes. If the trend is thought to continue after the last historical data
point it can be extrapolated to year n + k, where k is the number of years to
extrapolate forward. We then replace Rn by Rn+k in Equation (3), and get the k-year
ahead forward detrended indexes. For example, suppose we are looking at data from
a station which has experienced large growth in urbanisation in its surroundings in
recent years and where the urbanisation is still continuing. If we are considering a
contract for the winter, the most recent historical data would be from the previous
winter and we would need to extrapolate the estimated trend in order to capture the
trend introduced by continuing urbanisation.
Parametric trends
In this chapter, trends are assumed to be smooth and vary slowly in time since we
have assumed that jumps due to for example station relocations have been removed.
Therefore, it is often reasonable to approximate trends by parametric curves such as
linear or polynomial functions. The standard way of estimating the parameters of the
trend is by ordinary least squares (OLS), ie, minimising the sum:
∑(I – R )
i =1
i i
2
With yi denoting the year of index i, the trend Ri could then be parameterised by, for
example:
Ri = a + b y i (linear)
2
Ri = a + b yi + c yi (quadratic)
Ri = a exp(b yi ) (exponential)
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OLS estimates are known to be sensitive to extreme observations, so if outliers are W E AT H E R D E R I VAT I V E
present, a more robust estimation procedure may be needed – least absolute
n MODELLING AND
deviations for example (ie, minimise ∑ | Ii – Ri |. See Huber (1981) for a detailed
i=1
treatment of robust statistics).
2 VA L U AT I O N : A
S TAT I S T I C A L
Non-parametric trends
PERSPECTIVE
Sometimes it may be desirable to use a non-parametric trend if there is reason to
believe that parametric trends do not provide a satisfactory approximation for the
period considered. In such situations various non-parametric methods are available
(see, for example, Bowman and Azzalini, 1997). The simplest is called the “moving
average” method, where the trend in year i is estimated as the average of the
neighbouring years:
∑
1
Ri = Ii+w
2w + 1 i =–w
The number of neighbouring years, 2w + 1, is usually called the “window”, and the
years may be weighted such that years closer to the base year contribute more than
years that are further away. The main disadvantage of moving average estimation is
that it does not extrapolate the trend beyond the last historical year.
An alternative that allows extrapolation is the “loess” method (Cleveland and
Devlin, 1988), which is based on local parametric regressions. Linear loess, for
example, estimates the trend for year i by weighted linear regression, with most
weight on nearby years. Loess is known to have better theoretical properties than
moving average estimation, especially close to the edges of the observation window.
Figure 2 shows estimated linear trend and loess trends for the CDD example used
in this chapter. The difference between the two trendlines ranges from –26 to 26
CDDs.
DAILY DETRENDING
Detrending of daily temperatures can be done using the methods described above.
However, local or global warming effects may have different magnitudes in different
seasons (Hansen et al., 1996), thus create different trends at different times of the
year. This is not a problem when modelling annual indexes since such seasonality
does not appear, and similarly non-parametric trends adapt to each season.
Parametric trends, on the other hand, may need to be adapted to vary by time of the
year. One way this can be done is to estimate linear trends separately for each month
2. Estimated linear (dashed) and loess (solid) trends for the CDD example. The
original index values are connected by dotted lines.
3. Linear trends of average temperature at New York LaGuardia Airport for each
week of the year.
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negative or positive. For all the methods outlined above, the residuals should also be W E AT H E R D E R I VAT I V E
approximately normally distributed. With only a few index values, validation can be
MODELLING AND
a difficult task, and any external information on when changes in trends could have
occurred should be used when choosing a trend estimate. For example, many VA L U AT I O N : A
temperature measurements are made at airports, or in city centres, so information S TAT I S T I C A L
about when the airport or city has grown is useful for determining when a trend
PERSPECTIVE
could have started.
n ~
f̂ (x) =
1
n ∑
i =–1
1
h
kx – Ii
h
Here, k is a probability density function (PDF), and the degree of smoothing is
determined by the bandwidth, h. The effect of kernel smoothing is illustrated in
Figure 4, where three Gaussian kernel density estimates have been superimposed on
a histogram. Whereas the choice of smoothing function k is not very critical, the
bandwidth selection is extremely important for the overall shape of the estimated
distribution: the larger h, the more smoothing is obtained.
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W E AT H E R D E R I VAT I V E
5. Validation plots for a normal distribution for the CDD example
MODELLING AND
VA L U AT I O N : A
S TAT I S T I C A L
PERSPECTIVE
often useful to check the fit of specific characteristics of the distribution that are
more closely related to the actual purpose of the modelling. Since we are interested
in modelling payoffs, it is important to capture accurately those features of the index
distribution which affect the basic characteristics of the payoff distribution. Hence, if
we are modelling options or swaps, we should compare the model and empirical
LEV functions. As before, we prefer to look for straight lines when validating the fit,
so we plot the two against each other. The plot created this way is called an LL-plot,
and is shown in right panel of Figure 5 for the CDD example.
Envelopes
The validation plots described in the previous section are purely descriptive, and it
can sometimes be hard to see when deviations from a straight line are due simply to
sampling variation. In order to make them more quantitative we can add confidence
intervals to the plots. It is usually not possible to derive exact expressions for such
confidence intervals – we use simulation envelopes instead. This is done by
simulating samples of the same length as the historical data from the estimated
model; if the model is good, then the CDF of the samples should fall around the
historical CDF.
Simulation envelopes for the PP-plot are obtained as follows:
Step 1. Simulate a sample of the same length n as the historical data from the
estimated model.
Step 2. Calculate the empirical CDF from the sample at each historical index.
Step 3. Repeat Steps 1 and 2 K times and store the results.
Step 4. Sort the calculated CDF at each value of the historical indexes.
To achieve 90% confidence intervals we could simulate, say, K=100 samples and pick
4
out the fifth lowest and the fifth highest CDF values for each historical index. The
envelopes created this way are pointwise confidence intervals; there is 90%
probability that the historical CDF at a given point will fall within the envelopes.
Because points on the simulated CDFs are highly dependent this does not mean that
the probability of the full historical CDF falling within the envelopes is 90% to the
power of n.
Similarly for the QQ-plot and the LL-plot, we calculate the quantiles
corresponding to the quantiles of the historical indexes, and LEV at each historical
index. (Figure 10 shows an example of a QQ-plot within envelopes.)
GOODNESS-OF-FIT TESTS
Apart from graphical checks several goodness-of-fit tests are available, of which the
2
most common are chi-square (x ), Shapiro–Wilks, Kolmogorov–Smirnov and
Anderson–Darling. Because of the small number of historical indexes that are usually
❏ For a US cooling degree-day (CDD) index, the index approach uses only
information about how far above 65°F the temperature is. It does thus not
distinguish between days where the temperature is far below 65°, and days where
the temperature is just below 65°.
❏ Event indexes only use data from days on which events occurred. Data on all other
days is discarded.
❏ One-week contracts only use data for that week of the year. Data from other weeks
is discarded.
❏ For some indexes, in particular indexes relating to short periods and extreme
events, it may not be possible to find a suitable model for the index distribution.
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The daily model used for Figure 6 is the CJB model to be described later, but it W E AT H E R D E R I VAT I V E
must be noted that almost any model for daily temperatures would show this
MODELLING AND
apparent decrease in estimation uncertainty. This is because a daily model uses the
data more efficiently than an index model and because the comparison is based on VA L U AT I O N : A
the assumption that the model is correct (the simulation envelopes are created using S TAT I S T I C A L
the estimated model for both the index and the daily model). However, a bad daily
PERSPECTIVE
model could also produce significant bias, and hence reduce the value of increased
estimation accuracy. For this reason it is extremely important to validate a daily
model before using it for weather derivatives pricing; validation methods are
discussed in detail later.
Another reason for a thorough validation of daily validation models is that a daily
model may give a different index distribution from that given by the historical index
values (and from a normal distribution). Since a daily model is using data more
efficiently than an index model we can place more weight on the daily model results,
but only if it has been thoroughly validated.
Statistical modelling of daily temperatures has been a research subject for
decades (see for example the review in Wilks and Wilby, 1999) and, more recently, a
number of papers on weather derivative pricing that propose models for temperature
have been published (Alaton et al. (2002), Brody et al. (2002), Caballero et al.
(2002), Cao and Wei (2000), Davis (2001), Diebold and Campbell (2001), Dischel
(1998), Moreno (2000) and Torró et al. (2001)). Common to all of the above
referenced papers except Brody et al. (2002) and Cabellero et al. (2002) is that they
use ARMA-type models which will be discussed in more detail in the following
subsections.
We will start by discussing the basic steps of building a model for daily
temperatures and then show how statistical validation techniques are applied. The
model validation will show that ARMA-type models fail to validate well on two points:
For this reason we also show validation results for the model discussed in Caballero
et al. (2002) which, in general, validates much better than ARMA models for daily
temperatures. We conclude the section with a brief discussion of some of the
problems that still remain to be solved and which, to the authors’ knowledge, apply
to all published daily temperature models.
6. Potential gain in accuracy from daily modelling over index modelling. Normal
distribution index CDF (left) and index CDF derived from CJB model (right), both
with 90%-envelopes (dotted).
Ti = mi + si T ’i (4)
Non-parametric approaches
The simplest way to estimate the seasonal mean is to average each day of the year
over the historical data period, ie, the estimate for January 1 is the average of January
1 in all years and so on. When using this method, special care must be taken of leap
days. If the seasonal mean estimated this way is considered too ragged it can be
smoothed, by means of kernel smoothing, for example. One problem is that even
with smoothing, results are often too jumpy.
Parametric approaches
Another way of estimating the seasonal mean is by parameterising the mean
temperature using trigonometric functions. This has the advantage that leap days are
easy to take account of. We can estimate the mi using ordinary regression with mi
given by
mi = α cos
2π
365.25
i+ω (5)
K
∑α
2kπ
mi = k cos i+ω
k=1 365.25
While the parametric form in Equation (5) is very simple, it can be justified by plots
of power spectra of temperature anomalies which show surprisingly clear peaks at
365.25 days (and its harmonics).
The result of applying a seasonal linear trend and parametric seasonal cycles for
mean and standard deviation with two harmonics to the New York LaGuardia Airport
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example can be seen in Figure 7, which shows how the detrended daily temperatures W E AT H E R D E R I VAT I V E
are decomposed into seasonal mean, seasonal standard deviation and anomalies.
MODELLING AND
ANOMALY MODELLING VA L U AT I O N : A
The biggest challenge in modelling daily temperatures is to find an appropriate S TAT I S T I C A L
model for the anomalies. We have seen that the index distribution’s LEV function
PERSPECTIVE
plays an important role in deriving the moments of the payoff distribution. Similarly
there are functions of daily temperatures which are important for capturing
moments of the index distribution from a model for daily indexes. For example, it is
important to model both the seasonal cycle and the autocorrelation of temperatures
accurately in order to get a good estimate of the index mean and variance of degree-
day or average-temperature indexes. Consider, say, a CDD index. Using the
representation in Equation (4), and assuming that the daily temperature never falls
below 65°F, we have the following expressions for the mean and variance of the
index:
n
EI = ∑m – n65
i=1
i
VA L U AT I O N : A Here, n is the number of days in the contract and γ is the autocorrelation function
S TAT I S T I C A L (ACF) of the anomalies. From Equation (6) it can be seen that we would under-
estimate the index variance if the model ACF, γ, decays too quickly to zero.
PERSPECTIVE
What kind of ACF behaviour do daily temperatures show? Dependencies in day to
day temperature arise from complicated atmospheric, oceanic and land surface
processes, many of which evolve slowly. In particular, ocean circulation can have
cycles from years to decades and even centuries. It would thus not be surprising if
temperature were to show dependencies on long timescales. As we shall see later, the
ACF of temperature anomalies does indeed show relatively slow decay.
T’i = βT’i–1 + εi
Here T’i denotes the anomaly at day i and the εi are independent and identically
distributed random variables following a mean zero normal distribution. Despite its
simplicity an AR(1) process can be a useful model for a variety of problems, but is
unfortunately too simple for daily temperature anomalies (one reason being that the
ACF decays too quickly). A simple extension of the AR(1) process provides us with a
flexible class of models, known as ARMA models, which can be used to approximate
5
any stationary time-series model. The definition of an ARMA( p, q) process is:
The interpretation of the model is that the temperature today depends in a linear way
on the temperatures on the previous p days through the parameters φ1, ..., φp. Just as
in the AR(1) case random pertubations are added to reflect the fact that we do not
expect the temperature today to be a perfect linear function of the past p days’
temperatures. The θ1, ..., θq are parameters used to express linear dependence
between the random pertubations.
Although ARMA models can, in theory, approximate any time-series model, it is
actually not the best class of models for temperature anomalies. This is partly because
of the slow decay of the ACF of temperature anomalies (see Figure 8 and the
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subsection on validation using ACFs), which by Equation (6) implies that an ARMA W E AT H E R D E R I VAT I V E
model would result in underestimated variances for degree-day indexes – a fact that
6 MODELLING AND
has been recognised by many participants in the weather market for some time. If
we were to model a slower decay of the ACF using an ARMA model, we would need VA L U AT I O N : A
far more parameters than would be feasible to estimate in practice. A more S TAT I S T I C A L
parsimonious choice of model (in the following referred to as the CJB model) that
PERSPECTIVE
preserves much of the ARMA model flexibility but has slower decaying ACF is
described in Caballero et al. (2002).
In the following sections we illustrate classical statistical methods for model
validation, which provide more evidence on how ARMA models fail to provide
adequate modelling of daily temperatures and how the CJB model overcomes many
(but not all) of the problems associated with ARMA models.
AUTOCORRELATION FUNCTION
Equation (6) and the discussion following it highlighted the importance of capturing
the ACF of the temperature anomalies, making the comparison of the model ACF
with the empirical ACF an appropriate step in validation of the model. However,
since all ACFs start at one and usually decay quickly over the first few lags,
comparison can be difficult using the usual representation of an ACF. Instead, we
compare ACFs by plotting the logarithm of the ACF against logarithm of the lag. The
plot in Figure 8 is a plot of this type and emphasises what we have already
mentioned: that the ARMA model ACF decays too fast to capture the behaviour of the
empirical ACF.
DISTRIBUTION OF RESIDUALS
Residuals are the difference between the observed anomalies and the predicted
anomalies based on the past observations, ie, the historical one-step prediction
errors. The parameters used for the prediction are estimated from the full time-
series. For most models, including the two considered here, it is possible to derive
theoretical expressions for the distribution of the residuals. We can thus check the
DISTRIBUTION OF ANOMALIES
The next step in validation is the verification of the distribution of the anomalies. For
mathematical convenience most time-series models assume a normal distribution, so
a natural first step is to compare the empirical anomaly distribution with that of a
normal through PP- and QQ-plots. If a normal distribution is not suitable, it is often
possible to find a transformation that makes the anomaly distribution approximately
normal.
Models also exist for time-series with non-normal behaviour such as heavy-tailed
or skewed distributions. For such models, however, it can be difficult to verify when
the model is stationary and determine exactly what the marginal distributions are.
9. QQ-plot for the residuals using an ARMA(3,1) model (left) and CJB model
(right) for New York LaGuardia Airport.
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W E AT H E R D E R I VAT I V E
10. QQ-plot for the index distribution for New York LaGuardia Airport using an
ARMA(3,1) model (left) and CJB model (right). MODELLING AND
VA L U AT I O N : A
S TAT I S T I C A L
PERSPECTIVE
unresolved issues which means that even the CJB model may not be adequate in all
situations. In particular some locations show strong seasonal variation beyond that
of mean and standard deviation, which in turn means that both ARMA and CJB
models validate badly for these locations.
Another issue is that modelling daily temperatures for several locations
simultaneously is complicated by the fact that the spatial correlation structure is non-
stationary. This makes it difficult to exploit all the information in daily temperatures
and as a result dependencies between locations are usually modelled on an index
level instead (see the following section).
RANK CORRELATION
Rank correlation is a alternative way of measuring dependencies between
distributions. All values between one and minus one are possible whatever the
distribution, which makes interpretation of rank correlation easier than linear
correlation in the non-Gaussian case.
Rank correlation is calculated by transforming all indexes by their empircal CDF
and then computing the linear correlation between the transformed indexes. This is
equivalent to computing the linear correlation between the rank of the sorted
Pr = EP + λR (7)
where R is the risk measure and EP is the expected payoff. A measure of risk is
needed, and it is customary to use standard deviation or variance of the payoff for
this purpose. Alternatively we could use the difference between two quantiles such
as the median and the 5% quantile, whereby we get a risk measure which is more
7
akin to Value-at-Risk.
Equation (7) also allows the pricing of the contract against the full portfolio. To
do this we change the risk measure R to be a measure for the additional risk that is
taken on by trading the contract. Changes in any of the risk measures above could be
used for this purpose. For example, we could use the difference between the
standard deviation of the portfolio payoff with and without the contract as risk
measure R.
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called Risk Adjusted Return On Capital (RAROC) (Nakada et al., 1999) and W E AT H E R D E R I VAT I V E
investment equivalent reinsurance pricing (Kreps, 1999).
MODELLING AND
Consider the case where an option is sold at a price Pr. The price consists of the
discounted expected payoff and risk loading, L: VA L U AT I O N : A
S TAT I S T I C A L
Pr = EP/(1 + rf ) + L (8)
PERSPECTIVE
where rf is the risk-free interest rate. In addition to the premium income we allocate
an amount of capital A to the contract and invest Pr + A in risk-free securities. The
idea is now that the average return on allocated capital should equal the return from
an investment in an alternative instrument with the same risk. The expected Return
on Allocated Capital (RAC) is thus defined by
(1 + RAC) A = (1 + rf ) (Pr + A) – EP
Combining this with Equation (8) we get the following expression for the loading
L = (RAC – rf )/(1 + rf )A
Using the estimated payoff distribution we can get an idea of how risky the option is
and use this to find a reasonable target RAC which, in turn, gives the risk loading.
Several variations of this theme are possible, see Kreps (1999).
Other topics
We have seen in this chapter that valuation of weather derivatives is a broad subject
where many factors must be taken into account. While we have tried to cover the
majority of topics there are still some that we have left out and many which could
have been further elaborated.
ARBITRAGE PRICING
Arbitrage pricing is the standard way of pricing financial derivatives in a liquid
market. As noted in this chapter’s Introduction most weather derivative contracts are
not yet liquid enough to justify arbitrage pricing but some are now traded several
times a day. This makes it worthwhile to consider how arbitrage pricing for weather
derivatives may be done.
The basic principle of arbitrage pricing is that the cost of a derivative is the cost
of creating and managing a portfolio which replicates the payoff of the derivative
contract at maturity. The active management of the replicating portfolio is what is
usually called dynamic hedging. However, the underlying index of a weather
derivative cannot be traded and hence weather derivatives cannot be hedged this
way. Instead we could replicate the payoff of a weather derivative using other
weather derivatives. While this is possible in principle, the illiquidity of the current
weather market makes it prohibitively expensive for most types of contracts.
However, should the market become liquid enough, several arbitrage strategies
would be possible.
One strategy would be to use properties of forecasts to derive a theory for how
the market would price a weather swap. Since swaps can be used to hedge options,
this gives us a way of obtaining an arbitrage price for an option. The ideas behind
this are discussed in detail in Stephen Jewson’s contribution to the End Piece.
Some authors advocate hedging of weather derivatives with other derivatives such
as power or gas derivatives (Geman, 1999). However, such hedges are not likely to
be complete hedges and we are thus left with a basis risk. In order to find the price
of the basis risk we must model the weather derivative and the underlying of the
alternative hedge jointly, for example using methods similar to those previously
discussed in this chapter. Note also that whereas HDDs are highly correlated with gas
Conclusion
This chapter has described how weather derivatives can be valued by statistical and
actuarial methods based on historical data. It has given an overview of all the
important topics: estimation and adjustment of trends, modelling and validation of
detrended historical weather indexes and daily temperatures, accounting for index
dependencies and risk loading of expected payoffs.
As trading liquidity increases for certain contracts, aspects of arbitrage pricing will
become more important and in some cases replace actuarial methods. However, for
most contracts, the actuarial methods described in this chapter will continue to be
the main, and only reasonable, valuation approach that can be used.
1 The LEV function is often used in insurance for calculating mean loss to an excess
of loss reinsurance layer.
2 By “robust” we mean methods which, at the cost of accuracy, are less affected by
outliers than traditional methods.
3 Based on the authors’ own study using 50 years of data from 200 US stations.
4 In statistical literature the observed sample is often included in the K
simulations since the hypothesis modelled is a sample from the correct model. In
practice this distinction does not make a lot of difference.
5 It can be shown that for any autocovariance function γ (·) such that h→∞ϒ(h) =0,
and any integer k>0 it is possible to find an ARMA process with autocovariance
function (·) such that (h) = γ (h), h=0,1,...,k.
6 This is the authors’ own experience based on discussions with the major market
participants over the last three years.
7 Value-at-Risk (VAR) is a quantile (typically 5%) in the modelled profit and loss
distribution over a specified time period, and is one of the most common measures
of risk in finance.
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