PRICING WEATHER DERIVATIVES BASED ON MONTE CARLO SIMULATIONS

Abstract

In present the weather has very variation and non-predictable one of reason is Global Warming that affect to the mean of daily temperature rising. It has an enormous impact on business running therefore the weather derivatives (HDD/CDD Option) is financial instrument for hedging that risk. The main objective of this study is to find a pricing model for weather derivatives with payouts depending on temperature (HDD/CDD Option).

This study using the temperature modelling of Ornstein-Uhlenbeck and Dornier & Queruel and daily mean temperature of 120 Stations from Thai Meteorological Department (since 1/1/2013 to 12/31/2018) to approximation the temperature modelling parameters. Then, numerical pricing of HDD/CDD Option for each month using approximation formula as well as Monte Carlo Simulations.

Due to present, Thailand doesn’t have the weather derivative market cause the standard of temperature reference level haven’t determined and can’t observed a market price of risk on the market. Thus, this study has analyzed the sensitivity of temperature reference level and Market Price of Risk values as well.

This study shows that the prices from Monte Carlo Simulation move in closely the value of approximation formula with the error are between less than 1% to 4% on 20000 rounds. Also, when has changed the value between 1000 to 80000 rounds shows that the error will be decreasing as fast as exponential in 1000-10000 rounds meanwhile the time of calculation will be increasing as linearity. Conclusion, Monte Carlo Simulation can be efficient pricing the HDD/CDD Option based on round of simulation, perhaps the appropriate rounds shall be more than 10000 rounds.

The temperature reference level analysis shows that for the Monte Carlo Simulation and Approximation formula can be comparison each other, probably need to determine the appropriate values by monthly temperature historical data. It is found that HDD option pricing in January, the reference level shall be more than 29 Celsius meanwhile for CDD Option pricing in same month shall be less than 22 Celsius. For the market price of risk is too difficult to determine on market has no trade the weather derivatives. However, it shows that the prices have related with the market price of risk as the same direction.