In the previous two chapters we described burn analysis and index modelling. These are the most commonly used methods for the pricing of weather derivatives. Before we consider other more complex pricing methods based on the statistical modelling of daily temperatures we now digress and look at a number of interesting issues that arise in the pricing of single weather derivatives contracts. We start by discussing the so-called ‘greeks’. We then look at the relative importance of decisions concerning the choice of trend and the choice of distribution. We look at the relative accuracy of burn and index modelling, and the correlations between results from these two methods. We investigate the effects of varying the parameters of an option on the expected pay-off in order to develop some intuition about the different prices that occur for different contracts. Finally we address a number of other issues, including how to price multi-year contracts, how to use market data in pricing, how to perform static hedges and how to cope with leap-year-related issues.

Linear sensitivity analysis: the greeks

The pricing, trading and risk management of most kinds of financial options is based on the idea of maintaining a very low-risk portfolio using hedging, and, very often, frequent rehedging. In order to achieve effective hedging it is useful to calculate various partial derivatives of the arbitrage price of options, known as the ‘greeks’.