Pricing Temperature Weather Derivatives

Abstract: The key aim of the current paper is to analyse the plausibility of a pricing model for temperature weather derivatives. The historical data are studied in order to propose a stochastic process that describes temperature dynamics in three Swedish cities. The prices of the contracts in an incomplete market of weather derivatives are obtained using a constant positive market price of risk of a benchmark temperature derivative. Numerical examples of prices of contracts are shown using Monte-Carlo simulations and an approximation formula. The precision of the approximation formula is scrutinized depending on the changes in strike, market price of risk, risk-free rate, mean temperature, speed of mean-reversion and volatility. Moreover, theoretical prices of temperature options for two Swedish cities, which are not represented on the weather derivative market, are proposed.