Abstract
Weather derivatives play a major role in risk management of non-catastrophic weather market. The healthy development of the derivatives market is inseparable from the reasonable pricing of the product itself. As non-traditional financial derivatives, weather derivatives can provide a good risk hedging. Meanwhile, in the weather derivatives market, brokers play an even more important part than in the traditional financial derivatives market. Therefore, when pricing weather derivatives, we must take two factors into consideration, namely, brokers as market makers as well as the impact of their hedging cost on weather derivatives pricing. Based on the expected claims and risk payment of basic derivatives contracts, this paper is going to discuss weather derivatives pricing on the basis of hedging costs, while taking into account the impact of market makers’ hedging costs, risk aversion and existing positions.
Highlights
Weather derivatives constitute the core products in weather risk market
Weather derivatives market currently concentrated in North America, Western Europe and Japan and other developed economies, and it has implemented the transfer of general weather risk to third parties willing to and capable of dealing such risk successfully, met the demands of transfer and avoid the risk in energy, agriculture, tourism, transportation and other weather-sensitive industries
The pricing method of weather risk can draw lessons from that of insurance and traditional derivatives, such as actuarial pricing and market pricing. These pricing methods can price weather derivatives contracts well, but they are exercised in an isolated way for they merely focus on single contracts
Summary
Weather derivatives constitute the core products in weather risk market. Represented by CDD, HDD and EDD (Energy temperature value), weather derivatives continue to play a significant role in non-catastrophic weather markets risk management. As for the weather derivatives market, brokers who serve as market makers play a important role This is because the weather derivatives market, despite faced with strong demand, still lacks liquidity significantly, plus small trading volume as a result of respectively-long-time trading execution, which result in insufficient profit to support the brokerage industry operation. In the study of pricing of weather derivatives, it is necessary to consider the role of market makers, such as the effect of market makers’ hedging motivation and existing risk positions on pricing. For market makers, despite the unlikely implementation of fully hedging, the use of the relevant contracts to hedge some of the risk is achievable In this case, hedging may be static; it may need reassess as time goes by and the market condition changes. The cost of establishing hedging positions surely will affect the market makers’ bid or ask price to get the desired returns and the market pricing for weather derivatives
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