Model risk in the pricing of weather derivatives

Olivier Roustant (1, 2, 3) , Jean-Paul Laurent (4, 5) , Xavier Bay (1, 3) , Laurent Carraro (3)

1 CROCUS-ENSMSE - Equipe : Calcul de Risque, Optimisation et Calage par Utilisation de Simulateurs
2 GdR MASCOT-NUM - Méthodes d'Analyse Stochastique des Codes et Traitements Numériques
3 3MI-ENSMSE - Département Méthodes et Modèles Mathématiques pour l'Industrie
4 Financial models, Group ALM
5 SAF - Laboratoire de Sciences Actuarielle et Financière

Temperature modelling is a major issue for valuation of weather derivatives. Goodness of fit is usually assessed from historical data. However, estimation errors can result in large price uncertainty that may be problematic for practical applications. In this paper, we consider a temperature ARMA model and quantify the price uncertainties for weather Futures and weather options. Each price is seen as a random variable (which is a function of the parameters estimator), and we assess price uncertainty by giving confidence intervals. In addition, we look for sources of uncertainty, and point out the major defects of the model.

Keywords: weather derivative; model risk; price uncertainty

Domains: Modeling and Simulation

Olivier Roustant, Jean-Paul Laurent, Xavier Bay, Laurent Carraro. Model risk in the pricing of weather derivatives. Bankers Markets & Investors : an academic & professional review, 2004, 72, p. 5-16. ⟨emse-00699607⟩