142 Valuation and Risk Management of Weather Derivatives: The Application of CME Rainfall Index Binary Contracts Moreover, since Corporate Social Responsibility (CSR) and environmental, social and Governance (ESG) criteria are trending topics for companies around the world, we cannot emphasize enough the great significance of hedging precipitation risks. In addition to weather insurance, weather derivatives could be a good choice for the agricultural, transportation, and energy industries and utility companies. For example, the agricultural industry can reduce significant crop losses caused by extreme rainfall disaster with precipitation derivatives. Hydroelectric power generation with hedge structures can also cover low revenues due to periods of drought. 5. Conclusion In this paper, we discuss the valuation and risk management of CME rainfall index binary contracts, which have never been priced before. The underlying rainfall index is described with the occurrence model by using a first-order, two-state Markov chain, and the magnitude model with mixed exponential distribution. The seasonality characteristic of precipitation is captured by describing parameters in both models with the truncated Fourier series. The daily rainfall index is simulated by the Monte Carlo simulation, and the simulated monthly rainfall index is fitted with the NIG distribution. We value the rainfall index binary options with the Esscher transform. Finally, we perform several empirical analyses about the temporal behavior of the MPR calibrated with real market data from the CME. According to the results of empirical analysis, we draw the following conclusions: (1) Investors of rainfall index binary options can receive more information about the monthly rainfall index as time approaches the end of the contract period, which makes their estimations gradually more accurate. (2) The local weather and climate conditions should be important factors when issuing, trading, and analyzing weather derivatives. (3) The influence of natural catastrophes could make investors pour funds into the weather risk market, providing a chance to develop the weather derivatives market. (4) The participants of the precipitation derivatives market are mainly hedgers rather than speculators, which can explain the shrinking of this market. For extending the results of this paper and improving the accuracy of valuation, we propose several prospective studies as follows: (1) The occurrence model could be described with the higher-order Markovian property, which is also determined by the AIC and BIC. (2) More distributions could be considered to improve the fitness of the simulated index.
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