Quantifying Seasonal Weather Risk in Indian Markets: Stochastic Model for Risk-Averse State-Specific Temperature Derivative Pricing

TL;DR

This paper develops a stochastic model using a modified Ornstein-Uhlenbeck process with jumps to price weather derivatives in Indian markets, enabling state-specific risk management strategies for temperature fluctuations.

Contribution

It introduces a novel jump-diffusion model calibrated on Indian temperature data for accurate derivative pricing and tailored hedging strategies.

Findings

HDD options in colder states are significantly more expensive.

Volatility increases lead to higher option prices, with a 20% increase raising prices by 4.2%.

State-specific hedging strategies effectively manage temperature risks.

Abstract

This technical report presents a stochastic model for pricing weather derivatives and devising hedging strategies tailored to Indian markets. We model temperature dynamics using a modified Ornstein-Uhlenbeck process with jumps to account for sudden shocks, such as heatwaves and coldwaves. Historical data from 12 Indian states (1951-2023) is used for calibration, and Monte Carlo simulations are employed under the risk-neutral measure to price Heating Degree Days (HDD), Cooling Degree Days (CDD), and extreme event options. Sensitivity analysis reveals that a 20% increase in volatility leads to an approximate 4.2% increase in option prices, highlighting the critical impact of volatility on derivative pricing. Results show that HDD options in colder states like Himachal Pradesh are significantly more expensive, with prices reaching up to INR 684,693, while CDD options in hotter states like Gujarat are priced higher, up to INR 262,986. A comprehensive portfolio analysis indicates that investing INR 120,000 in HDD put options in Uttar Pradesh yields an expected payoff of INR 132,369, resulting in a return on investment (ROI) of 10.3%. Conversely, a similar investment in Karnataka yields a negative ROI of -66.7% due to its milder climate. Hedging strategies are tailored to each state's climatic risk, with recommendations to buy 90.66 HDD put options at a strike of 90.89 in Uttar Pradesh and invest in CDD call options in Gujarat. These insights offer practical solutions for managing temperature-related financial risk in energy and agriculture, providing actionable, state-specific hedging strategies for diverse climatic scenarios in India.