Pricing of temperature-based weather options for Turkey

Weather derivatives provide better risk management alternatives for industries, which are exposed to weather-based risks. Dynamic pricing of weather derivatives requires a suitable underlying temperature model. This paper is the first to model the average daily temperatures and prices of heating/cooling degree days (HDD/CDD) option contracts for Istanbul, Turkey. We model daily average temperatures using the mean-reverting Ornstein-Uhlenbeck (OU) process both with constant and time-varying mean reversion parameters. HDD/CDD options for Istanbul are priced using analytical approximation and Monte Carlo simulations. In most cases estimates are lower when time-varying mean reversion model is used. We also discuss several issues on the importance of weather derivatives markets for developing countries.