Teddy Oetomo

Index Design and Implications for Index Tracking

Tracking error in index fund performance is unavoidable. It arises because the underlying index is measured as a paper portfolio, and it is assumed perfect replication can be achieved instantaneously and without cost. Tracking error has two components: exogenous tracking error (the result of index rules and maintenance procedures applied to the underlying index) and endogenous tracking error (the result of the individual activities of index managers managing open-end passive funds). An examination of a sample of S&P 500 index mutual funds upon changes to the Index Divisor identifies a number of exogenous factors that are important determinants of tracking error for S&P 500 index funds.

Hot or Cold?: A Comparison of Different Approaches to the Pricing of Weather Derivatives

This article reviews six different temperature forecasting models proposed by prior literature for pricing weather derivatives. Simulation of these models is used to estimate daily temperature and, as a consequence, the metrics used for pricing temperature derivatives. The models that rely on an auto-regressive moving average (ARMA) process exhibit a better goodness-of-fit than those that are established under Monte Carlo simulations. However, the superiority of ARMA-type models is not reflected over the forecast horizon. Over that period, the models that rely on Monte Carlo simulations exhibit a tendency to over-forecast the monthly accumulated heating degree day (AccHDD) index and to under-forecast the monthly accumulated cooling degree day (AccCDD) index. Alternatively, models established under the ARMA approach both under-forecast and over-forecast the monthly accumulated indices. All models consistently over-forecast the average daily temperature. The most appropriate pricing model varies between cities and months. Finally, the models examined in this study generate a more accurate AccHDD futures price than the price traded on the market. However, the ability of these models to estimate the AccCDD futures price is significantly poorer than that of the market.

Weather Derivatives: An Attractive Additional Asset Class

This article demonstrates that companies from a wide range of industries are able to hedge against the volatility of their revenues more efficiently by resorting to non-standardized weather derivative contracts. In addition, including weather derivatives contracts as an additional asset class produces significant diversification benefits for conventional portfolios. This study proposes that institutional investors write non-standardized contracts for their corporate clients, repackage them, and offer them as an additional asset class. This strategy would help to mitigate the lack of liquidity inherent in non-standardized contracts and, simultaneously, provide significant diversification benefits for the conventional portfolio.