An Actuarial Pricing Method for Air Quality Index Options

Area of Science:

• Environmental Economics
• Financial Risk Management
• Atmospheric Science

Background:

• Poor air quality negatively impacts social and economic activities.
• Financial derivatives are crucial for risk hedging.
• Enterprises face operational risks due to air pollution.

Purpose of the Study:

• To develop and price Air Quality Index (AQI) options for hedging enterprise operational risks.
• To establish a framework for using AQI options in financial risk management.
• To demonstrate the practical application of AQI options for businesses affected by air pollution.

Main Methods:

• Utilized an expanded Ornstein-Uhlenbeck model with AR-GARCH to predict Air Quality Index (AQI).
• Constructed an average AQI as the underlying index for AQI options.
• Employed an actuarial pricing method with an Esscher transform for AQI options.
• Developed payoff functions for hedging operational risks.

Main Results:

• Successfully priced AQI options using data from Xi'an, China.
• Demonstrated the application of AQI options for a tourism enterprise in hedging operational risk.
• Validated the effectiveness of AQI options in mitigating financial losses from air pollution.

Conclusions:

• AQI options offer a viable financial instrument for enterprises to hedge against operational risks associated with air pollution.
• The developed methodology for AQI options is applicable to other cities and regions.
• Trading AQI options can enhance business resilience in environments with significant air quality concerns.