Weather derivatives are often written in terms of HDD and CDD, heating degree da

Question

Weather derivatives are often written in terms of HDD and CDD, heating degree days and cooling degree days, where on a given day, HDD = max(0,65-A) CDD = max(0,A-65) A = average of the day’s low and high temperatures. The cumulative HDD and cumulative CDD over a span of time is just the sum of HDDs or CDDs. Heating degree days are a measure of the amount you have to heat in order to keep a temperature of 65 and cooling degree days are a measure of the amount you have to cool in order to keep an average temperature of 65. Suppose that each day in July (1st – 31st ) the minimum temperature is 68 and the maximum is 82. What is the payoff from a call option on the cumulative CDD during July with a strike of 250 and a payment of $5,000 per degree day?

Explanation / Answer

Hi,

First lets calculate

A = average of the day’s low and high temperatures

A= (68+82)/2 = 75

CDD = max(0, 75-65)

CDD = 10

Cummulative CDD = 10*31 = 310

Option payoff = Max(0, 310 - 250) *5000 = 300000

Hence total payoff is 300000.

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