Abstract:
On the temperature derivative market, modeling temperature volatility is an important issue for pricing and hedging. In order to apply 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 inter temporal 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 normalisation a pure standardised Gaussian variable appears. Earlier work investigated this temperature risk in dfferent locations and showed that neither parametric component functions nor a local linear smoother with constant smoothing parameter are flexible enough to generally describe the volatility 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 of localised temperature risk process by achieving excellent normal risk factors.