Localizing Temperature Risk

Wolfgang Karl Härdle, Brenda López Cabrera, Ostap Okhrin, Weining Wang

Research output: Contribution to journalArticlepeer-review

Abstract

On the temperature derivative market, modeling temperature volatility is an important issue for pricing and hedging. To apply the pricing tools of financial mathematics, one needs to isolate a Gaussian risk factor. A conventional model for temperature dynamics is a stochastic model with seasonality and intertemporal autocorrelation. Empirical work based on seasonality and autocorrelation correction reveals that the obtained residuals are heteroscedastic with a periodic pattern. The object of this research is to estimate this heteroscedastic function so that, after scale normalization, a pure standardized Gaussian variable appears. Earlier works investigated temperature risk in different locations and showed that neither parametric component functions nor a local linear smoother with constant smoothing parameter are flexible enough to generally describe the variance process well. Therefore, we consider a local adaptive modeling approach to find, at each time point, an optimal smoothing parameter to locally estimate the seasonality and volatility. Our approach provides a more flexible and accurate fitting procedure for localized temperature risk by achieving nearly normal risk factors. We also employ our model to forecast the temperaturein different cities and compare it to a model developed in 2005 by Campbell and Diebold. Supplementary materials for this article are available online.
Original languageEnglish
Pages (from-to)1491-1508
Number of pages18
JournalJournal of the American Statistical Association
Volume111
Issue number516
Early online date13 May 2016
DOIs
Publication statusPublished - 4 Jan 2017

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