Title: Can we use the Black-Scholes-Merton model to value temperature options?

Authors: Gunter Meissner; James Burke

Addresses: Shidler College of Business, University of Hawaii, 2404 Maile Way, Honolulu, HI 96822, USA. ' C/O Pedro Villarreal, Shidler College of Business, 2404 Maile Way, Honolulu, HI 96822-2457, USA

Abstract: In 1973, Fisher Black, Myron Scholes and separately Robert Merton derived the Black-Scholes-Merton (BSM) model, which was rewarded the Nobel Prize in 1997. Despite its limitations, the model has survived until today as the dominant pricing model for standard and exotic European style options. The model owes its success to its simplicity, high intuition and versatility. Burn analysis, which is typically applied in practise to price temperature options, lacks a rigorous mathematical foundation and can lead to arbitrage opportunities. We find that the BSM model despite its limitations is an adequate pricing model, which is superior to Burn analysis.

Keywords: temperature options; burn analysis; Black-Scholes-Merton model; lognormal distribution; options pricing; modelling.

DOI: 10.1504/IJFMD.2011.045601

International Journal of Financial Markets and Derivatives, 2011 Vol.2 No.4, pp.298 - 313

Available online: 23 Feb 2012 *

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