Controlling business risks using weather derivatives

In this paper, we develop a certainly equivalent pricing formula for weather derivatives and discuss its property in the over the counter market. First, we provide a utility based approach to find the future price of weather derivatives, where the contract is assumed to be carried out between an insurance company and an industry that run a project affected by weather index, say, the average temperature. This situation is typical in the Japanese weather derivatives market, because most contracts are sold by insurance/finance companies and their price should be determined by taking asymmetric positions into account. Using an exponential utility function, it is shown that dealings may be executed at an equilibrium price with a suitable volume adjustment. Finally, we estimate the hedge effect of weather derivatives on the electricity revenue using future and put option contracts.