A weather derivative is a financial instrument used by companies or individuals to hedge against the risk of weather-related losses. The seller of a weather derivative agrees to bear the risk of disasters in return for a premium. If no damages occur before the expiration of the contract, the seller will make a profit—and in the event of unexpected or adverse weather, the buyer of the derivative claims the agreed amount. The profitability and revenues of virtually every industry—agriculture, energy, entertainment, construction, travel, and others—depend to a great extent on the vagaries of temperature, rainfall, and storms.
Weather Derivatives: Answers to 10 most popular questions – Part B
Market Futures: Introduction to Weather Derivatives
Even in our advanced, technology-based society, we still live largely at the mercy of the weather. It influences our daily lives and has an enormous impact on corporate revenues and earnings. Until recently, there were very few financial tools offering companies protection against weather-related risks. However, the inception of the weather derivative —making the weather a tradeable commodity—has changed all this. Here we look at how the weather derivative was created, how it differs from insurance and how it works as a financial instrument.
This paper prices weather derivatives of two typical processes: the Ornstein—Uhlenbeck process and the Ornstein—Uhlenbeck process with jump diffusions. Efficient one sided Crank—Nicolson schemes are developed to solve the convection dominated partial differential and integral-differential equation corresponding to the two processes, respectively. For second order convergence, the one sided Crank—Nicolson schemes may utilize piecewise cubic interpolations to approximate the jump conditions in degree days direction. The unconditional stability is then obtained through the local von Neumann analysis. As extensive numerical experiments shown, the schemes are highly efficient and accurate, and can serve as competitive and practical pricing instruments in weather derivative markets.