Stochastic Modeling of Daily Rainfall for Pricing Weather Derivatives

Abstract

Weather derivatives are getting to be powerful tools for weather risk hedging. A popular method which draws out valid prices of weather derivatives is a stochastic modeling approach. In the method, expected payoffs of weather derivatives based on stochastic weather models are regarded as their valid prices. Although useful stochastic models of temperature have been shown, stochastic models of daily rainfall are still being developed. Therefore, it is considered that pricing of daily rainfall derivatives is difficult. This paper shows a new stochastic daily rainfall model for pricing daily rainfall options. The new model in which a modified geometric distribution model is applied can express stochastic features of daily rainfall. Furthermore, this paper also shows that the combination model of the Markov chain rainy day model and the new model can express stochastic features and risks of daily rainfall option payoffs. © 2004, The Institute of Electrical Engineers of Japan. All rights reserved.