Taming the Elements: An. Analysis of Temperature Derivatives and Spatial Basis Risk in the Netherlands

Abstract

The key aim of this thesis discuss and apply a pricing model for temperature deriva- tives with payoffs deriving from Dutch average daily temperatures. We first run a thorough analysis of 52 years of daily average temperatures in nine dutch cities and use a Ornstein-Uhlenbeck process with seasonal volatility to capture the features of daily average temperatures. We use explicit pricing formulas and a Monte Carlo sim- ulation to approximate the price of HDD and CAT options and propose an approach to estimate the market price of risk that relies on the Newton-Raphson method. The thesis also investigates the effects of spatial basis risk in the Netherlands and sug- gests trading a new security which combines an exchange traded derivative and a basis derivative, along with a discussion on accounting for this security in a profit maximization framework.