A weather derivative (or a temperature derivative ) whose underlying asset is a specific temperature index, i.e. an index of changes in weather conditions. The accumulated heating/cooling degree days (HDDs and CDDs) are commonly used as underlying assets. These indices are calculated by accumulation of the differences between a base temperature and the actual temperatures for a given period of time. Temperature options on HDDs and CDDs are mainly used as a risk reduction strategy especially by energy companies that are in the business of supplying gas or electric power.
Since temperature movement is unlike that of securities or similar assets, that is this movement is not a tradable asset, pricing temperature options using Black-Scholes yields no reliable results. Therefore, some attempts focused, instead, on the expected utility theory which uses the marginal substitution value approach. However, underlying assets, HDDs and CDDs, are described as following a geometric Brownian motion process, just like other financial assets that underlie ordinary options.
This option is also broadly known as a weather option.
Comments