A regime switching model for temperature modeling and applications to weather derivatives pricing

In this study, we propose a regime-switching model for temperature dynamics, where the parameters depend on a Markov chain. We improve upon the traditional models by modeling jumps in temperature dynamics via the chain itself. Moreover, we compare the performance of the proposed model with the exist...

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Bibliographic Details
Published in:Mathematics and financial economics 2020, Vol.14 (1), p.1-42
Main Authors: Türkvatan, Aysun, Hayfavi, Azize, Omay, Tolga
Format: Article
Language:English
Subjects:
Applications of Mathematics
Derivatives
Economic models
Economic Theory/Quantitative Economics/Mathematical Methods
Economics
Finance
Insurance
Macroeconomics/Monetary Economics//Financial Economics
Management
Markov analysis
Markov chains
Mathematics
Mathematics and Statistics
Prices
Quantitative Finance
Statistics for Business
Switching
Weather
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Summary:In this study, we propose a regime-switching model for temperature dynamics, where the parameters depend on a Markov chain. We improve upon the traditional models by modeling jumps in temperature dynamics via the chain itself. Moreover, we compare the performance of the proposed model with the existing models. The results indicate that the proposed model outperforms in the short time forecast horizon while the forecast performance of the proposed model is in line with the existing models for the long time horizon. It is shown that the proposed model is a relatively better representation of temperature dynamics compared to the existing models. Furthermore, we derive prices of weather derivatives written on several temperature indices.
ISSN:1862-9679
1862-9660
DOI:10.1007/s11579-019-00242-0