Pricing Weather Derivatives

This article briefly reviews the background of weather derivatives. The primary goal is to develop a pricing scheme that accommodates and reflects their unique characteristics. Because the underlying indexes of weather derivatives are not traded, a no‐arbitrage model cannot be directly applied for the purpose of pricing. The actuarial technique is a feasible choice but cannot be applied in the traditional fashion, because the historical data are characterized by long‐term variability and trends that are difficult to define and correct based purely on the data. The pricing scheme developed in this article attempts to address these concerns by combining information from both empirical analysis of historical data and numerical simulations.