Weather Derivative Pricing and the Detrending of Meteorological Data: Three Alternative Representations of Damped Linear Detrending

Abstract

It is often desirable to remove the trends from historical meteorological data prior to using that data for the pricing of weather derivatives. In previous articles we have introduced the method of damped linear detrending and argued that it is an effective way to remove trends when the trends are approximately linear. In this article we show that damped linear detrending can be interpreted in three different ways: as a mixture of the linear and flat-line models, as a linear model with the trend slope reduced, and as a linear model with reverse extrapolation.

Keywords: weather derivatives, trends, detrending

JEL Classification: G12, G13