Title : Stochastic option pricing model for rainfall derivatives - A case study of sugarcane production in valle del cauca, Colombia
Sugarcane is one of the most important commercial crops and it is the most valuable crop as it is the basic raw material for the manufacture of sugar, ethanol and jaggery. Sugarcane cultivation was started in Indian Subcontinent which was exported to other countries. Colombia is the world’s second largest non-centrifugal sugar producer in the world. The primary source of water for agricultural production for most of the world is rainfall and water are the key input to agricultural production and therefore fluctuations in water availability may impact agricultural productivity and revenue. Climate change and agriculture are interrelated processes, both of which take place on a global scale. Global warming affects agriculture in a number of ways, including through changes in average temperatures, rainfall, and climate extremes (e.g., heat waves); changes in pests and diseases; changes in atmospheric carbon dioxide and ground-level ozone concentrations; changes in the nutritional quality of some foods; and changes in sea level. In the past decade, the literature on weather derivatives has focused on the temperature market because most traded weather derivatives are based on temperature indices. Several economic sectors, however, are exposed to rainfall risk. For example, farmers and financial investors are affected by indirect losses caused by scarce or abundant rainfall. With rainfall derivatives, firms have the possibility to transfer precipitation risk to the capital market. The main goal of this study is to construct the Stochastic Option Pricing Model and valuation approach of Rainfall Derivatives in Valle Del Cauca, Colombia Sugarcane market and to develop a flexible framework for modelling and pricing rainfall risk. The main goal of study is fourfold: 1) First, we begin our approach to brief introduction to rainfall derivative market. 2) We construct the mathematical for making bond with rainfall derivative financial derivatives (rainfall options). 3) Then, we extend this approach to focus on valuation of option pricing model. 4) Finally, use the 10 years historical data from rainfall station, Valle Del Cauca, Colombia, study and evaluate the option pricing model. In addition, this paper ends with conclusion.