Pricing rainfall derivatives in the equatorial Pacific

Abstract

PurposeIn the equatorial Pacific, rainfall is affected by global climate phenomena, such as El Niño Southern Oscillation (ENSO). However, current publicly available methodologies for valuing weather derivatives do not account for the influence of ENSO. The purpose of this paper is to develop a complete framework suitable for valuing rainfall derivatives in the equatorial Pacific.Design/methodology/approachIn this paper, we implement a Markov chain for the occurrence of rain and a gamma model for the conditional quantities using vector generalized linear models (VGLM). The ENSO forecast probabilities reported by the International Research Institute for Climate and Society (IRI) are included as independent variables using different alternatives. We then employ the Esscher transform to price rainfall derivatives.FindingsThe methodology is applied and calibrated using the historical rainfall data collected at the El Dorado airport weather station in Bogotá. All the estimated coefficients turn out to be significant. The results prove more accurate than those of Markovian gamma models based on purely statistical descriptions of the daily rainfall probabilities.Originality/valueThis procedure introduces the novelty of incorporating variables related to the climatic phenomena, which are the forecast probabilities regularly published for the occurrence of El Niño and La Niña.