Abstract:
This paper proposes a consistent approach to the pricing of weather derivatives. Since
weather derivatives are traded in an incomplete market setting. standard hedging based pricing methods
cannot be applied. The growth optimal portfolio, which is interpreted as a world stock index is used
as a benchmark or numeralre such that all bench marked derivative price processes are martingales. No
measure trnnsfonnation is needed for the proposed fail pricing. For weather derivative payoffs that are
independent of the value of the growth optimal portfolio it is shown that the classical actuarial pricing
methodology is a particular case of the fair pricing concept. A discrete time model is constructed to
approximate historical weather characteristics. The fair prices of some pnnicular weather derivatives
arc derived using historical and Gaussian residuals. The question of weather risk as diversifiable risk
is also discussed.
