Modeling the Dynamics of Temperature with a View to Weather Derivatives

43 Pages Posted: 6 Dec 2009 Last revised: 22 Jan 2010

See all articles by Gkaren Papazian

Gkaren Papazian

Accenture

George S. Skiadopoulos

Queen Mary, University of London, School of Economics and Finance; University of Piraeus

Date Written: January 19, 2010

Abstract

The accurate specification of the process that the temperature follows over time is a prerequisite for the pricing of temperature derivatives. To this end, a horse race of alternative specifications of the dynamics of temperature is conducted by evaluating their out-of-sample forecasting performance under different evaluation metrics and forecast horizons. An extensive dataset of the daily average temperature measured at different locations in Europe and U.S. is employed. We find that a developed principal components model and a combination forecasts model perform best in U.S. and Europe, respectively. Point forecasts for popular temperature indices are formed, as well. The results have implications for the pricing and trading of the fast growing class of temperature derivatives, as well as for forecasting temperature.

Keywords: Point forecasts, Predictability, Principal Components, Temperature, Temperature indices

JEL Classification: C53, G10, G12, G13

Suggested Citation

Papazian, Gkaren and Skiadopoulos, George, Modeling the Dynamics of Temperature with a View to Weather Derivatives (January 19, 2010). Available at SSRN: https://ssrn.com/abstract=1517293 or http://dx.doi.org/10.2139/ssrn.1517293

Gkaren Papazian

Accenture ( email )

Greece

George Skiadopoulos (Contact Author)

Queen Mary, University of London, School of Economics and Finance

Lincoln's Inn Fields
Mile End Rd.
London, E1 4NS
United Kingdom

University of Piraeus ( email )

80 Karaoli & Dimitriou Str.
18534 Piraeus, 185 34 -GR
Greece

HOME PAGE: http://web.xrh.unipi.gr/faculty/gskiadopoulos/

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