Weather Forecasting for Weather Derivatives Research Proposal

Weather Forecasting for Weather Derivatives - Research Proposal Example The goal is to determine which method leads to the smallest forecasting error. The forecast is performed only for the one time step ahead and is not required to provide long lasting forecast. Since their inception in 1996, weather derivatives have grown in large quantities. Today, weather derivatives are being used for hedging purposes by companies and industries, whose profits can be adversely affected by unseasonal weather or, for speculative purposes by hedge funds and others interested in capitalizing on those volatile markets. A weather derivative is a financial instrument that has a payoff derived from variables such as temperature, snowfall, humidity and rainfall. However, it is estimated that 98-99% of the weather derivatives now traded are based on temperature. Temperature contracts have as an underlying variable, temperature indices such as Heating Degree Days (HDD) or Cooling Degree Days (CDD) defined on average daily temperatures. The list of traded contracts is extensive and constantly evolving. In the Chicago Mercantile Exchange (CME) there are traded weather contracts based on an index of Cumulative Average Temperature (CAT) for European cities for May to September (Zapranis). Many weather derivatives are traded long before the start of the contract and long before there are any useful forecasts which can indicate the likely weather during the contract period. For instance, contracts for the winter period may be traded in the preceding spring and early summer. In this case, only historical observational data are required for derivative valuation. It is also common for weather derivatives to be priced just before and during the period of the contract. There are two main reasons for this. The ï ¬ rst is that weather derivatives are traded at these times. This can be for economic hedging reasons, or purely for speculation. The second is that companies that have traded a weather derivative often need to track the value of the