Weather Derivative Pricing and the Year-Ahead Forecasting of Surface Air Temperature: An Empirical Evaluation of Damped Linear Detrending

Abstract

The pricing of temperature derivatives is often based on statistical methods that predict the surface air temperature a year in advance. We perform an empirical comparison of three simple methods for such year-ahead temperature forecasting and draw clear conclusions about their relative merits. The three methods we consider are the standard flat-line and best-fit linear detrending methods and the recently introduced damped linear detrending method.

Keywords: Weather derivatives, detrending, damped linear detrending, shrinkage

JEL Classification: G12, G13