Wavelet Neural Networks: With Applications in Financial Engineering, Chaos, and Classification

9 Modeling Financial Wind Derivatives

Weather derivatives are financial tools that can help organizations or individuals to reduce risk associated with adverse or unexpected weather conditions and can be used as part of a risk management strategy. Weather derivatives linked to various weather indices, such as rainfall, temperature, or wind, are traded extensively in CME as well as on the OTC market. The electricity sector is especially sensitive to the temperature and wind since temperature affects the consumption of electricity while wind affects production of electricity in wind farms. Hence, it is logical that energy companies are the main investors of the weather market. In Chapter 8 a detailed framework for modeling and pricing temperature derivatives was developed. In this chapter we focus on wind derivatives.

The notional value of the wind-linked securities traded is around $36 million, indicating a large and growing market (WRMA, 2010). However, after the close of the U.S. Future Exchange, wind derivatives have been traded OTC. A demand for these derivatives exists. However, investors hesitate to enter into wind contracts. The main reasons for the slow growth of the wind market compared to temperature contracts are the difficulty in modeling wind accurately and the challenge of finding a reliable model for valuing related contracts. As a result, there is a lack of reliable valuation framework that makes financial institutions reluctant to quote prices over these derivatives. ...