Paper: arXiv 2409.04541

Authors: Soumil Hooda, Shubham Sharma, Kunal Bansal

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.

Complexity vs Empirical Score

  • Math Complexity: 6.5/10
  • Empirical Rigor: 7.5/10
  • Quadrant: Holy Grail — high math complexity, high empirical rigor

Why this score: The paper presents a solid stochastic model using a modified Ornstein-Uhlenbeck process with jumps applied to extensive historical Indian weather data (1951-2023). It provides strong empirical rigor through state-level calibration, Monte Carlo pricing, sensitivity analysis, and explicit hedging strategies tailored for regional energy and agricultural risks.

Research Flowchart

  flowchart TD
    A[Goal: Price Weather Derivatives & Manage Risk in Indian Markets] --> B[(Data Input: Historical Temp Data 1951-2023 for 12 Indian States)]
    B --> C[Methodology: Modified Ornstein-Uhlenbeck Process with Jumps]
    C --> D[Simulation: Risk-Neutral Monte Carlo Pricing for HDD/CDD Options]
    D --> E[Analysis: Sensitivity Analysis & Portfolio ROI Evaluation]
    E --> F[Outcomes: HDD in HP ~INR 684k, CDD in GJ ~INR 263k, UP Portfolio ROI +10.3%]
    F --> G[Tailored Hedging Strategies: Buy HDD Put Options in UP, CDD Call Options in GJ]