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Introduction

Lvy driven Ornstein-Uhlenbeck Model


Futures Pricing under Lvy driven OU model
Conclusion
Weather Derivative Pricing and Application to
Canadian Data
Kaijie Cui
University of Calgary, Department of Mathematics and Statistics
May 3, 2012
Presented by Kaijie Cui North/South Dialogue Talk
Introduction
Lvy driven Ornstein-Uhlenbeck Model
Futures Pricing under Lvy driven OU model
Conclusion
Contents
1
Introduction
2
Lvy driven Ornstein-Uhlenbeck Model
Motivation
Model
Data Analysis
3
Futures Pricing under Lvy driven OU model
CAT futures
CDD and HDD futures
4
Conclusion
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Introduction
Lvy driven Ornstein-Uhlenbeck Model
Futures Pricing under Lvy driven OU model
Conclusion
Temperature Derivatives
The impact of weather on many commercial and
recreational activities is signicant and varies both
geographically and seasonally.
Many businesses, including agriculture, insurance, energy
and tourism, are either favorably or adversely affected by
weather.
Denition
Weather derivatives are contingent claims written on weather
indices, which in turn are variables whose values are
constructed from weather data.
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Introduction
Lvy driven Ornstein-Uhlenbeck Model
Futures Pricing under Lvy driven OU model
Conclusion
Weather indices
Commonly referenced weather indices:
DAT: daily average temperature, T(s),
CAT: cumulative average temperature,
_

1
T(s)ds,
CDD: cooling degree days,
_

1
max(T(s) c, 0)ds,
HDD: heating degree days,
_

1
max(c T(s), 0)ds,
can be get from the National Climate Data and Information
Archive (NCDIA). Others like precipitation, snowfall, wind and
so on can also be the underlying of weather derivatives.
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Introduction
Lvy driven Ornstein-Uhlenbeck Model
Futures Pricing under Lvy driven OU model
Conclusion
Statement of Problem
The weather derivatives
traded in an incomplete market setting,
correlation between weather indices and most established
nancial indices is negligible.
The weather indices
long-term seasonal variations and trends,
strong relativity of daily data,
residuals may not be normally distributed.
Presented by Kaijie Cui North/South Dialogue Talk
Introduction
Lvy driven Ornstein-Uhlenbeck Model
Futures Pricing under Lvy driven OU model
Conclusion
Motivation
Model
Data Analysis
Motivation
Our data set contains daily temperatures (measured in
centigrade) for Calgary, AB. and Toronto, ON. in Canada
provided by NCDIA over Jan. 1th 2001 to Jan. 1th 2011.
0 500 1000 1500 2000 2500 3000 3500
40
30
20
10
0
10
20
30
Day
M
e
a
n
te
m
p
e
ra
tu
re
Calgary mean temperature (1/1/20011/1/2011)
0 500 1000 1500 2000 2500 3000 3500
30
20
10
0
10
20
30
40
Day
M
e
a
n
te
m
p
e
ra
tu
re
Toronto mean temperature(1/1/20011/1/2011)
Figure: Daily mean temperature from Calgary and Toronto for 10
years.
Presented by Kaijie Cui North/South Dialogue Talk
Introduction
Lvy driven Ornstein-Uhlenbeck Model
Futures Pricing under Lvy driven OU model
Conclusion
Motivation
Model
Data Analysis
Non-normality
40 30 20 10 0 10 20 30
0
50
100
150
200
250
300
350
400
Daily average temperature in Calgary
F
r
e
q
u
e
n
c
y
30 20 10 0 10 20 30 40
0
50
100
150
200
250
300
350
400
Daily average temperature in Toronto
F
r
e
q
u
e
n
c
y
Figure: Histogram of daily average temperature in Calgary and
Toronto.
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Introduction
Lvy driven Ornstein-Uhlenbeck Model
Futures Pricing under Lvy driven OU model
Conclusion
Motivation
Model
Data Analysis
Model
Suppose daily average temperature follows
dT
t
= ds
t
+(T
t
s
t
)dt +
t
dL
t
, (1)
where s
t
is the seasonal patten referred to as the seasonality of
the temperature and is the speed that temperature reverts to
mean,
t
is assumed to be a measurable and bounded function
represents the seasonal volatility, L
t
is the Lvy process with
independent and stationary increments. This model was rstly
introduced by Dornier and Queruel (2000) with Brownian
motion noise. Such model is particularly suitable to capture the
evolution of temperature dynamics.
Presented by Kaijie Cui North/South Dialogue Talk
Introduction
Lvy driven Ornstein-Uhlenbeck Model
Futures Pricing under Lvy driven OU model
Conclusion
Motivation
Model
Data Analysis
Model
T
t
= s
t
+ (T
0
s
0
)e
t
+
_
t
0

u
e
(tu)
dL
u
. (2)
By subtracting T
t
from T
t+1
, approximating the stochastic
integral,
T
t
= s
t
(1 e

)(T
t
s
t
) + e

_
t+1
t

u
e
(tu)
dL
u
,
T
t
= s
t
(1 e

)(T
t
s
t
) + e

t
L
t
.
Then add T
t
s
t
:=

T
t
to both sides

T
t+1
= e


T
t
+ e

t
. (3)
Presented by Kaijie Cui North/South Dialogue Talk
Introduction
Lvy driven Ornstein-Uhlenbeck Model
Futures Pricing under Lvy driven OU model
Conclusion
Motivation
Model
Data Analysis
Model
In summary, we will have the following expression for modeling
the daily average temperature step by step.
T
t
= s
t
+ c
t
+
t
,
where T
t
is the daily average temperature at day t , s
t
is the
seasonal component of the daily average temperature, c
t
is the
cyclical component derived from Equation 3, and
t
is the
stochastic or random noise of the daily temperature.
Presented by Kaijie Cui North/South Dialogue Talk
Introduction
Lvy driven Ornstein-Uhlenbeck Model
Futures Pricing under Lvy driven OU model
Conclusion
Motivation
Model
Data Analysis
Trends
Figure: Linear trends of Calgary and Toronto for recent 10 years.
Presented by Kaijie Cui North/South Dialogue Talk
Introduction
Lvy driven Ornstein-Uhlenbeck Model
Futures Pricing under Lvy driven OU model
Conclusion
Motivation
Model
Data Analysis
Seasonality
Choose to use simple sine function to model the seasonality.
s
t
= a
0
+ a
1
sin(
2
365
(t t
0
)),
where a
0
is the mean level of temperature, a
1
is amplitude of
the mean temperature and t
0
represents the a phase angle.
Table: Estimated parameters for seasonal function
Parameters Calgary Toronto
a
0
4.614 8.924
a
1
12.03 13.67
t
0
72.85 67.83
R
2
0.6753 0.8331
Presented by Kaijie Cui North/South Dialogue Talk
Introduction
Lvy driven Ornstein-Uhlenbeck Model
Futures Pricing under Lvy driven OU model
Conclusion
Motivation
Model
Data Analysis
Seasonality
Figure: Seasonal trends for Calgary and Toronto daily mean
temperature.
Presented by Kaijie Cui North/South Dialogue Talk
Introduction
Lvy driven Ornstein-Uhlenbeck Model
Futures Pricing under Lvy driven OU model
Conclusion
Motivation
Model
Data Analysis
Cyclicity
Recall that based on Equation 3, we can model the cyclical
component by recursive regression
c
t
= e


T
t1
= e

(T
t1
s
t1
).
Table: e

, and R
2
in regression
Parameters Calgary Toronto
e

0.7858 0.7018
0.2411 0.3541
R
2
0.6172 0.4924
Presented by Kaijie Cui North/South Dialogue Talk
Introduction
Lvy driven Ornstein-Uhlenbeck Model
Futures Pricing under Lvy driven OU model
Conclusion
Motivation
Model
Data Analysis
Cyclicity
0 100 200 300 400 500 600 700 800
0.5
0
0.5
1
Lag
S
a
m
p
le

A
u
t
o
c
o
r
r
e
la
t
io
n
Calgary residuals (ACF)
0 100 200 300 400 500 600 700 800
0.5
0
0.5
1
Lag
S
a
m
p
le

A
u
t
o
c
o
r
r
e
la
t
io
n
Toronto residuals (ACF)
0 100 200 300 400 500 600 700 800
0.5
0
0.5
1
Lag
S
a
m
p
le

A
u
t
o
c
o
r
r
e
la
t
io
n
Calgary squared residuals (ACF)
0 100 200 300 400 500 600 700 800
0.5
0
0.5
1
Lag
S
a
m
p
le

A
u
t
o
c
o
r
r
e
la
t
io
n
Toronto squared residuals (ACF)
Figure: The empirical autocorrelation function for the residuals and
squared residuals after regression.
Presented by Kaijie Cui North/South Dialogue Talk
Introduction
Lvy driven Ornstein-Uhlenbeck Model
Futures Pricing under Lvy driven OU model
Conclusion
Motivation
Model
Data Analysis
Residuals
0 500 1000 1500 2000 2500 3000 3500
6
4
2
0
2
4
6
Day
R
e
s
id
u
a
l
Calgary residuals
0 500 1000 1500 2000 2500 3000 3500
6
4
2
0
2
4
6
Day
R
e
s
id
u
a
l
Toronto residuals
Figure: Residuals after linear regression of deseasonalized mean
daily temperatures.
Presented by Kaijie Cui North/South Dialogue Talk
Introduction
Lvy driven Ornstein-Uhlenbeck Model
Futures Pricing under Lvy driven OU model
Conclusion
Motivation
Model
Data Analysis
Residuals

t
= e

t
.

t
:=

t
e

=
t

t
.
To t
t
,
organize the residuals into 365 groups, one for each day of
years;
nd the means of the squared residuals in each group,

2
t
= E[
2
t
];
take logarithm and use three days moving average to
smooth estimates.
Presented by Kaijie Cui North/South Dialogue Talk
Introduction
Lvy driven Ornstein-Uhlenbeck Model
Futures Pricing under Lvy driven OU model
Conclusion
Motivation
Model
Data Analysis
Residuals
0 50 100 150 200 250 300 350
0
5
10
Calgary residual variance
0 50 100 150 200 250 300 350
0
1
2
3
Calgary moving average
0 50 100 150 200 250 300 350
0
2
4
6
Toronto residual variance
0 50 100 150 200 250 300 350
0
1
2
3
Toronto moving average
Figure: The empirical and smoothed seasonal variation.
Presented by Kaijie Cui North/South Dialogue Talk
Introduction
Lvy driven Ornstein-Uhlenbeck Model
Futures Pricing under Lvy driven OU model
Conclusion
Motivation
Model
Data Analysis
Residuals

t
=

t

t
.
0 100 200 300 400 500 600 700 800
0.5
0
0.5
1
Lag
S
a
m
p
le

A
u
t
o
c
o
r
r
e
la
t
io
n
Calgary residuals (ACF)
0 100 200 300 400 500 600 700 800
0.5
0
0.5
1
Lag
S
a
m
p
le

A
u
t
o
c
o
r
r
e
la
t
io
n
Toronto residuals (ACF)
0 100 200 300 400 500 600 700 800
0.5
0
0.5
1
Lag
S
a
m
p
le

A
u
t
o
c
o
r
r
e
la
t
io
n
Calgary squared residuals (ACF)
0 100 200 300 400 500 600 700 800
0.5
0
0.5
1
Lag
S
a
m
p
le

A
u
t
o
c
o
r
r
e
la
t
io
n
Toronto squared residuals (ACF)
Figure: The empirical autocorrelation function for the residuals and
squared residuals after removing seasonal variation.
Presented by Kaijie Cui North/South Dialogue Talk
Introduction
Lvy driven Ornstein-Uhlenbeck Model
Futures Pricing under Lvy driven OU model
Conclusion
Motivation
Model
Data Analysis
Residuals

t
= c
1
+
N

i =1
(c
2i
sin(iwt ) + c
2i +1
cos(iwt )).
Table: Truncated Fourier series parameters
c
1
c
2
c
3
w
Calgary 4.424 1.633 0.1912 0.0167
Toronto 4.33 1.082 0.2108 0.01526
Presented by Kaijie Cui North/South Dialogue Talk
Introduction
Lvy driven Ornstein-Uhlenbeck Model
Futures Pricing under Lvy driven OU model
Conclusion
Motivation
Model
Data Analysis
Residuals
0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1
0
0.2
0.4
0.6
0.8
1
0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1
0
0.2
0.4
0.6
0.8
1
0 50 100 150 200 250 300 350
1
2
3
4
5
6
7
8
9


Estimation variation for Calgary
Truncated Fourier series fit
0 50 100 150 200 250 300 350
2
3
4
5
6
7
8


Estimation variation for Toronto
Truncated Fourier series fit
Figure: Fit of seasonal variation by truncated Fourier series
variations.
Presented by Kaijie Cui North/South Dialogue Talk
Introduction
Lvy driven Ornstein-Uhlenbeck Model
Futures Pricing under Lvy driven OU model
Conclusion
Motivation
Model
Data Analysis
Residuals
0 100 200 300 400 500 600 700 800
0.5
0
0.5
1
Lag
S
a
m
p
le

A
u
t
o
c
o
r
r
e
la
t
io
n
Calgary residuals (ACF)
0 100 200 300 400 500 600 700 800
0.5
0
0.5
1
Lag
S
a
m
p
le

A
u
t
o
c
o
r
r
e
la
t
io
n
Toronto residuals (ACF)
0 100 200 300 400 500 600 700 800
0.5
0
0.5
1
Lag
S
a
m
p
le

A
u
t
o
c
o
r
r
e
la
t
io
n
Calgary squared residuals (ACF)
0 100 200 300 400 500 600 700 800
0.5
0
0.5
1
Lag
S
a
m
p
le

A
u
t
o
c
o
r
r
e
la
t
io
n
Toronto squared residuals (ACF)
Figure: ACF and squared residuals ACF plots of residuals after
removing truncated Fourier series variations.
Presented by Kaijie Cui North/South Dialogue Talk
Introduction
Lvy driven Ornstein-Uhlenbeck Model
Futures Pricing under Lvy driven OU model
Conclusion
Motivation
Model
Data Analysis
Fitting noise
3 2 1 0 1 2 3
0
0.05
0.1
0.15
0.2
0.25
0.3
0.35
0.4
Data
D
e
n
s
ity


Calgary residuals
Normal fit
3 2 1 0 1 2 3
0
0.05
0.1
0.15
0.2
0.25
0.3
0.35
0.4
Data
D
e
n
s
ity


Toronto residuals
Normal fit
Figure: Normal t plot of residuals of Calgary and Toronto data.
Table:
2
-statistics and P-values for residuals of Calgary and Toronto
Calgary Toronto

2
105.43 53.69
P-value 8.11 10
20
2.71 10
9
Presented by Kaijie Cui North/South Dialogue Talk
Introduction
Lvy driven Ornstein-Uhlenbeck Model
Futures Pricing under Lvy driven OU model
Conclusion
Motivation
Model
Data Analysis
Fitting noise
Propose to use the family of generalized hyperbolic Lvy
motion to model the noise.
Denition
The one-dimensional generalized hyperbolic distribution is
dened by the Lebesgue density:
gh(x; , , , , ) =a(, , , )(
2
+ (x )
2
)
(1/2)/2
K
1/2
(
_

2
+ (x )
2
) exp((x ))
a(, , , ) =
(
2

2
)
/2

2
1/2

(
_

2
)
Presented by Kaijie Cui North/South Dialogue Talk
Introduction
Lvy driven Ornstein-Uhlenbeck Model
Futures Pricing under Lvy driven OU model
Conclusion
Motivation
Model
Data Analysis
Fitting noise
Table: Estimations of the tted generalized hyperbolic distribution

Calgary 27.5526 26.5012 21.7036 0.7168 5.3918
Toronto 16.8141 31.3320 24.8234 7.4866 10.9646
0 0.2 0.4 0.6 0.8 1
0
0.1
0.2
0.3
0.4
0.5
0.6
0.7
0.8
0.9
1
0 0.2 0.4 0.6 0.8 1
0
0.1
0.2
0.3
0.4
0.5
0.6
0.7
0.8
0.9
1
5 4 3 2 1 0 1 2 3 4
0
0.1
0.2
0.3
0.4
0.5
0.6
0.7
0.8
0.9
1
x
F
(x
)
Empirical CDF


CDF of simulations
CDF of Calgary residuals
5 4 3 2 1 0 1 2 3 4 5
0
0.1
0.2
0.3
0.4
0.5
0.6
0.7
0.8
0.9
1
x
F
(x
)
Empirical CDF


CDF of simulations
CDF of Toronto residuals
Figure: CDF of simulated series and residual observations.
Presented by Kaijie Cui North/South Dialogue Talk
Introduction
Lvy driven Ornstein-Uhlenbeck Model
Futures Pricing under Lvy driven OU model
Conclusion
CAT futures
CDD and HDD futures
CAT futures
Consider price dynamics of futures written on Cumulative
average temperature indices over time period [
1
,
2
],
1
<
2
.
Assume the daily average temperature dynamics follows Lvy
driven OU model above.
e
r (
2
t)
E
Q
__

2

1
T
u
du F
CAT
(t ,
1
,
2
)|F
t
_
= 0.
F
CAT
(t ,
1
,
2
) = E
Q
_
_

2

1
T
u
du|F
t
_
.
Presented by Kaijie Cui North/South Dialogue Talk
Introduction
Lvy driven Ornstein-Uhlenbeck Model
Futures Pricing under Lvy driven OU model
Conclusion
CAT futures
CDD and HDD futures
CAT futures
Assume (t ) : [0, T] R is a measurable and bounded
function. Consider process
Z

t
= exp(
_
t
0
(s)dL
s

_
t
0
((s))ds).
The probability measure Q

is well dened by the Esscher


transform:
Q

(A) = E[1
A
Z

T
].
Presented by Kaijie Cui North/South Dialogue Talk
Introduction
Lvy driven Ornstein-Uhlenbeck Model
Futures Pricing under Lvy driven OU model
Conclusion
CAT futures
CDD and HDD futures
CAT futures
Theorem
The future price F
CAT
(t ,
1
,
2
) at time t
1
written on a CAT
index over the time interval [
1
,
2
] is given by
F
CAT
(t ,
1
,
2
) =
_

2

1
s(u)du
+
1
(T(t ) s(t ))(e
(
2
t)
e
(
1
t)
)
+
1
_

2
t

u
(e
(
2
u)
1)

((u))du

1
_

1
t

u
(e
(
1
u)
1)

((u))du
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Introduction
Lvy driven Ornstein-Uhlenbeck Model
Futures Pricing under Lvy driven OU model
Conclusion
CAT futures
CDD and HDD futures
CDD and HDD futures
CDD:
_

1
max(T
u
c, 0)du =
_

1
(T
u
c)
+
du;
HDD:
_

1
max(c T
u
, 0)du =
_

1
(c T
u
)
+
du.
For CDD future(HDD is similar):
e
r (
2
t)
E
Q
_
_

1
(T
u
c)
+
du F
CDD
(t ,
1
,
2
)|F
t
_
= 0,
F
CDD
(t ,
1
,
2
) = E
Q
_
_

1
(T
u
c)
+
du|F
t
_
.
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Introduction
Lvy driven Ornstein-Uhlenbeck Model
Futures Pricing under Lvy driven OU model
Conclusion
CAT futures
CDD and HDD futures
CDD and HDD futures
Theorem
For random variable X() =
_

0

u
e
(u)
dL
u
,
E
Q
[exp(i X())] = exp(()), the logarithm of characteristic
function, () of X() under measure Q

is given by
() =
_

0
((t )e
(t)
i (t ))dt
_

0
(i (t ))dt ,
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Introduction
Lvy driven Ornstein-Uhlenbeck Model
Futures Pricing under Lvy driven OU model
Conclusion
CAT futures
CDD and HDD futures
CDD and HDD futures
Theorem
(Fourier Inversion Theorem) Let F(x) denote the cumulative
density function of the random variable X(), the corresponding
probability function f (x) is integrable in Lebesgue sense, i.e.
f (x) L. The characteristic function of X() is dened as
(t ) =
_
+

e
itx
f (x)dx, and () L is given. Then,
f (x) =
1
2
_
+

e
itx
(t )dt =
1

_
+
0
e
itx
(t )dt .
Presented by Kaijie Cui North/South Dialogue Talk
Introduction
Lvy driven Ornstein-Uhlenbeck Model
Futures Pricing under Lvy driven OU model
Conclusion
CAT futures
CDD and HDD futures
CDD and HDD futures
By Fourier Inversion Theorem, consider the probability density
function f (x) and DFT X
k
=

N1
n=0
x
n
e
ik
2
N
n
, using trapezoid
rule to approximate the integral
f (x) =
1

_
+
0
e
itx
(t )dt
=
1

_
e
it
0
x
(t
0
) + e
it
N
x
(t
N
)
2
+
N1

k=1
e
it
k
x
(t
k
)t
_

N1

k=0

k
e
it
k
x
(t
k
)t ,
where

k
=
_
1
2
, k=0;
1, otherwise.
Presented by Kaijie Cui North/South Dialogue Talk
Introduction
Lvy driven Ornstein-Uhlenbeck Model
Futures Pricing under Lvy driven OU model
Conclusion
CAT futures
CDD and HDD futures
CDD and HDD futures
Based on the construction of Chourdakis (2004), let = t ,
then t
k
= k, grid spacing =
2
N
, then the return grids
x
j
= b +j , (4)
where b is a parameter to control the return range. Under this
setting,
f (x
j
)
1

N1

k=0

k
e
i k(b+j )
(k)
=
N1

k=0
1

k
e
i kb
e
ik
2
N
j
(k)
=
N1

k=0
f
k
e
ij
2
N
k
, f
k
=
1

k
e
i kb
(k), j = 0, ..., N 1.
(5)
Presented by Kaijie Cui North/South Dialogue Talk
Introduction
Lvy driven Ornstein-Uhlenbeck Model
Futures Pricing under Lvy driven OU model
Conclusion
CAT futures
CDD and HDD futures
CDD and HDD futures
Theorem
Numerically, the CDD futures F
CDD
(t ,
1
,
2
) at time t
1
written on a CDD index over time interval [
1
,
2
] can be
approximated by
F
CDD
(t ,
1
,
2
) =

u=
1

x
k
cs
u
+(T
0
s
0
)e
u
[x
k
+ (s
u
+ (T
0
s
0
)e
u
c)]f (x
k
, u)u,
where f (x
k
, u) is given by Equation 5 and x
k
are constructed in
approach using fast Fourier transform to compute f (x
k
, u), refer
to Equation 4.
Presented by Kaijie Cui North/South Dialogue Talk
Introduction
Lvy driven Ornstein-Uhlenbeck Model
Futures Pricing under Lvy driven OU model
Conclusion
CAT futures
CDD and HDD futures
CDD and HDD futures
Theorem
The relation between future prices of CAT, CDD and HDD is
formulated as
F
CDD
(t ,
1
,
2
) = c(
2

1
) F
CAT
(t ,
1
,
2
) F
HDD
(t ,
1
,
2
).
Presented by Kaijie Cui North/South Dialogue Talk
Introduction
Lvy driven Ornstein-Uhlenbeck Model
Futures Pricing under Lvy driven OU model
Conclusion
Conclusion
Modelling of Daily average temperature variations by a
mean-reverting Ornstein-Uhlenbeck process driven by
general Levy Process was proposed;
Tested and tted the model to Canadian temperature data
(Calgary AB. and Toronto ON.);
The prices of futures written on CAT, CDD and HDD
indices are derived explicitly.
Presented by Kaijie Cui North/South Dialogue Talk
Introduction
Lvy driven Ornstein-Uhlenbeck Model
Futures Pricing under Lvy driven OU model
Conclusion
Future works
Implement of pricing formulas and methods;
Working on a CAR(Continuous-time autoregressive) model
driven by Lvy process;
Combine CAR model with regime-switching model.
Presented by Kaijie Cui North/South Dialogue Talk
Introduction
Lvy driven Ornstein-Uhlenbeck Model
Futures Pricing under Lvy driven OU model
Conclusion
Reference
1 Benth F. E. and

Saltyt
_
e-Benth J. (2007), The volatility of
temperature and pricing of weather derivatives", Quant.
Finance, 7(5), pp. 553-561.
2 Dornier F. and Queruel M. (2000) Caution to the wind",
EPRM, August, pp.30-32.
3 Chourdakis K. (2004), Option pricing using the fractional
FFT", J. Comp. Finance, 8(2), pp. 1-18.
Presented by Kaijie Cui North/South Dialogue Talk
Introduction
Lvy driven Ornstein-Uhlenbeck Model
Futures Pricing under Lvy driven OU model
Conclusion
Thanks!
Presented by Kaijie Cui North/South Dialogue Talk