Modeling temperature dynamics and pricing temperature derivatives: an investigative Kenyan example

Abstract

The following research project will propose a mean-reverting stochastic process for modelling the daily average temperature in the Kenyan context. The proposed modelling framework will then be used to price a weather derivatives instrument. First, a general description of weather derivatives is provided along with their applicability in the market. Different models postulated in modeling the dynamics of temperature are then outlined. The Alaton model is then highlighted; a model that prescribes an Ornstein – Uhlenbeck process for the modeling of temperature. The methodology is then outlined as well as a description of the calibration of the model. Thereafter, the aforementioned model dynamics are used in pricing a CDD call option.