The volatility of temperature and pricing of weather derivatives

Abstract

We propose an Ornstein–Uhlenbeck process with seasonal volatility to model the time dynamics of daily average temperatures. The model is fitted to approximately 45 years of daily observations recorded in Stockholm, one of the European cities for which there is a trade in weather futures and options on the Chicago Mercantile Exchange. Explicit pricing dynamics for futures contracts written on the number of heating/cooling degree-days (so-called HDD/CDD futures) and the cumulative average daily temperature (so-called CAT futures) are calculated, along with a discussion on how to evaluate call and put options with these futures as underlying.