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Stochastic Modelling of Temperature Variations with a View Towards Weather Derivatives

  • Fred Espen Benth
  • Jurate Saltyte-Benth
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    Daily average temperature variations are modelled with a mean-reverting Ornstein-Uhlenbeck process driven by a generalized hyperbolic Levy process and having seasonal mean and volatility. It is empirically demonstrated that the proposed dynamics fits Norwegian temperature data quite successfully, and in particular explains the seasonality, heavy tails and skewness observed in the data. The stability of mean-reversion and the question of fractionality of the temperature data are discussed. The model is applied to derive explicit prices for some standardized futures contracts based on temperature indices and options on these traded on the Chicago Mercantile Exchange (CME).

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    File URL: http://www.tandfonline.com/doi/abs/10.1080/1350486042000271638
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    Article provided by Taylor & Francis Journals in its journal Applied Mathematical Finance.

    Volume (Year): 12 (2005)
    Issue (Month): 1 ()
    Pages: 53-85

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    Handle: RePEc:taf:apmtfi:v:12:y:2005:i:1:p:53-85
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    1. Neil Shephard, 2005. "Stochastic volatility," Economics Series Working Papers 2005-W17, University of Oxford, Department of Economics.
    2. Sean D. Campbell & Francis X. Diebold, 2003. "Weather Forecasting for Weather Derivatives," NBER Working Papers 10141, National Bureau of Economic Research, Inc.
    3. Black, Fischer & Scholes, Myron S, 1973. "The Pricing of Options and Corporate Liabilities," Journal of Political Economy, University of Chicago Press, vol. 81(3), pages 637-54, May-June.
    4. Tim Bollerslev, 1986. "Generalized autoregressive conditional heteroskedasticity," EERI Research Paper Series EERI RP 1986/01, Economics and Econometrics Research Institute (EERI), Brussels.
    5. Peter Alaton & Boualem Djehiche & David Stillberger, 2002. "On modelling and pricing weather derivatives," Applied Mathematical Finance, Taylor & Francis Journals, vol. 9(1), pages 1-20.
    6. Ole E. Barndorff-Nielsen, 1997. "Processes of normal inverse Gaussian type," Finance and Stochastics, Springer, vol. 2(1), pages 41-68.
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