Air pollution option pricing model based on AQI

Air pollution severely impacts various social and economic sectors, underscoring the importance of a financial air quality derivatives market. This article focuses on designing an Air quality index (AQI) options contract, employing financial derivatives to hedge against air pollution risks. Next, the AQI day values are used to establish an Ornstein-Uhlenbeck (O-U) mean recovery model, from October 28, 2013 to May 31, 2017, in Shijiazhuang. Accounting for variation of the sequence over time, we obtain significant seasonal fluctuations and variances in the AQI data, used in estimating the model parameters. Finally, under the risk-neutral principle, three types of ADI index options contracts, with different maturities, are simulated, with pricing derived through the binomial tree model. Results show: the O-U model time series can improve accuracy when forecasting AQI changes. The use of a new binomial tree model can reasonably price derivatives of air quality. The AQI based air pollution option product, described in this paper, can hedge operating risks for companies in industries that are seriously affected by air pollution.