Pricing weather derivatives with the market price of risk extracted from the utility indifference valuation

Abstract

In this paper, a PDE (partial differential equation) based approach is presented to price weather derivatives with the market price of risk extracted from the utility indifference valuation. Assuming that the underlying temperature follows an Ornstein–Uhlenbeck process, the PDEs associated with the utility indifference valuation are established and then solved numerically using a one-sided finite difference scheme. The solution procedure is validated through numerical experiments for the utility indifference futures prices, and then applied to price more complicated weather derivatives such as options.