Temperature Models for Pricing Weather Derivatives
Quantitative Finance, Vol.12, No. 3, March 2012, 489-500
24 Pages Posted: 11 Oct 2008 Last revised: 18 May 2012
Date Written: March 11, 2010
We present four models for predicting temperatures that can be used for pricing weather derivatives. Three of the models have been suggested in prior literature, and we suggest another model which uses splines to remove trend and seasonality effects from temperature time series in a flexible way. Using historical temperature data from 35 weather stations across the United States, we test the performance of the models by evaluating virtual heating degree days (HDD) and cooling degree days (CDD) contracts. We find that all models perform better when predicting HDD indices than predicting CDD indices. However, all models based on a daily simulation approach significantly underestimate the variance of the errors.
Keywords: Weather derivatives, temperature, heating degree days, cooling degree days, daily simulation
JEL Classification: C52, G13, Q40
Suggested Citation: Suggested Citation