Weather Derivative CME Prices vs Speedwell Model Prices
Weather Derivative CME Prices vs Speedwell Model Prices
This mini article compares the CME end-of-day prices with the Speedwell model prices. In truth, the purpose is not to compare, although this is interesting, but to demonstrate a few fundamental features of the climate risk market
·????????It is a data market first
·????????Market and model prices
·????????Volatility converges towards zero
For this mini-study, we will use the following:
Let us dive straight into it.
Derivative 1 : New York La Guardia Feb 2023 HDD Swap
The CME end of day prices and the Speedwell Model prices starts at a very close level, then mirror one another and end up being exactly the same value: 679.5
Derivative 2 : Chicago Feb 2023 HDD Swap
The CME end of day prices and the Speedwell Model prices starts at a very close level, then mirror one another and end up being exactly the same value: 872.
Do you start seeing a pattern here? Let us confirm it with another randomly selected derivative.
Derivative 3: New York La Guardia Nov-Mar 2023 HDD Swap
In this case, the CME and the Speedwell prices start at a different level before they converge toward one another. In my opinion, the market was clearly either overestimating the price at the start or was paying a hefty premium.
No matter their local small differences, market and model prices always end up being the same.
In fact, we can say this differently, the volatility of a typical weather derivative index always converges toward zero:
Do you know what is mind blowing here? I did not even bother to fine tune whatever default index model was configured in the Speedwell Environmental System install I got my hands on. I think it was LOESS 60%, whereas by default I prefer a stiffer LOESS or kernel model personally. For this quick analysis, I knew I could get away with it :-), because all models will behave and converge the same way!
As a conclusion: Make sure you have the right data and system
In fact, you can ask the price to any of the many risk takers in the marketplace, the market price you will receive back is 95% a model price with a 5% 'personal adjustment' component (liquidity, portfolio, RoVaR constraints) !
If you would like to find out more about weather derivatives, visit the CME weather page: https://www.cmegroup.com/trading/weather/
or simply contact us.
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Speedwell Climate is the leading provider of data for the climate risk transfer business. We also provide the Speedwell Environmental System for pricing and managing climate derivative contracts. Speedwell Climate also provides independent valuations of weather derivatives
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