Abstract
Weather derivatives are contingent claims with payoff based on a pre-specified weather index. Firms exposed to weather risk can transfer it to financial markets via weather derivatives. We develop a utility-based model for pricing baskets of weather derivatives under default risk on the issuer side in over-the-counter markets. In our model, agents maximise the expected utility of their terminal wealth, while they dynamically rebalance their weather portfolios over a finite investment horizon. Using dynamic programming approach, we obtain semi-closed forms for the equilibrium prices of weather derivatives and for the optimal strategies of the agents. We give an example on how to price rainfall derivatives on selected stations in China in the universe of a financial investor and a weather exposed crop insurer.
Highlights
Weather derivatives (WDs) are contingent claims with payoffs determined by future weather events as temperature, snowfall, and rainfall
We develop a utility-based model for pricing baskets of weather derivatives under default risk on the issuer side in over-the-counter markets
Whereas non-zero default probability has no effect on the supply of the WDs, the demand curve shifts downwards which results in lower equilibrium prices for the rainfall options
Summary
Weather derivatives (WDs) are contingent claims with payoffs determined by future weather events as temperature, snowfall, and rainfall. Consumption based model of Cao and Wei (2004) prices multiple WDs in an extended pure exchange economy of Lucas (1978) on the macroeconomic level and is not feasible for a limited number of weather market participants and a short contract duration typical for OTC markets. We contribute to this literature by providing a model for pricing baskets of customised WDs on multiple dependent underlying indices.
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