CONSISTENT FACTOR MODELS FOR TEMPERATURE MARKETS

We propose an approach for pricing and hedging weather derivatives based on including forward looking information about the temperature available to the market. This is achieved by modeling temperature forecasts by a finite dimensional factor model. Temperature dynamics are then inferred in the short end. In analogy to interest rate theory, we establish conditions which guarantee consistency of a factor model with the martingale dynamics of temperature forecasts. Finally, we consider a specific two-factor model and examine in more detail pricing and hedging of weather derivatives in this context.