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Localizing Temperature Risk

Research output: Contribution to journalArticlepeer-review


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


Publication details

JournalJournal of the American Statistical Association
DateAccepted/In press - 13 May 2016
DateE-pub ahead of print - 13 May 2016
DatePublished (current) - 4 Jan 2017
Issue number516
Number of pages18
Pages (from-to)1491-1508
Early online date13/05/16
Original languageEnglish


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.

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