On the pricing and hedging of precipitation derivatives

Abstract

In this paper, we present a new precipitation model based on a multi-factor Ornstein-Uhlenbeck approach of pure-jump type. In this setup, we derive a representation for the related precipitation swap price process and infer its risk-neutral time dynamics. We further deduce a pricing formula for European options written on the precipitation swap and obtain the minimal variance hedging portfolio in the underlying weather market. In the second part of the paper, we provide a precipitation swap price representation under future information modeled by an initially enlarged filtration. We finally derive a formula for the associated information premium and investigate minimal variance hedging of precipitation derivatives under future information.

Keywords

Precipitation model / Precipitation swap price / Minimal variance hedging / Option pricing / Information premium / Future information / Stochastic differential equation / Enlarged filtration / Stochastic maximum principle / Malliavin calculus / Fourier transform

References

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