The pricing of degree‐day weather options

Abstract

This paper presents a model and framework for pricing degree‐day weather derivatives when the weather variable is a non‐traded asset. Using daily weather data from 1840S1996, it is shown that a degree‐day weather index exhibits stable volatility and satisfies the random walk hypothesis. The options prices from the recommended model are compared to a typical insurance‐type model. The results show that the insurance model overprices the option value at‐the‐money, and this may explain why the bid‐ask spread in the weather derivatives market is sometimes very large.