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Modeling temperature behaviors: Application to weather derivative valuation

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  • Jr‐Wei Huang
  • Sharon S. Yang
  • Chuang‐Chang Chang

Abstract

This article investigates temperature behavior to develop a temperature model. The proposed ARFIMA Seasonal GARCH model that allows for long memory effects and other important temperature properties provides better goodness of fits and forecasting accuracy using daily average temperatures in six U.S. cities. The effect of temperature behavior on pricing temperature derivatives is analyzed. We propose an equilibrium option pricing framework for HDD and CDD forward and option contracts under the ARFIMA Seasonal GARCH model. The investigation of temperature properties and the valuation framework in this study contributes to the development of a standardized temperature model for weather derivative markets.

Suggested Citation

  • Jr‐Wei Huang & Sharon S. Yang & Chuang‐Chang Chang, 2018. "Modeling temperature behaviors: Application to weather derivative valuation," Journal of Futures Markets, John Wiley & Sons, Ltd., vol. 38(9), pages 1152-1175, September.
    • Handle: RePEc:wly:jfutmk:v:38:y:2018:i:9:p:1152-1175
    DOI: 10.1002/fut.21923
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    References listed on IDEAS

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    Cited by:

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