A stochastic volatility model for the valuation of temperature derivatives

Aur\'elien Alfonsi and Nerea Vadillo

Papers from arXiv.org

Abstract: This paper develops a new stochastic volatility model for the temperature that is a natural extension of the Ornstein-Uhlenbeck model proposed by Benth and Benth (2007). This model allows to be more conservative regarding extreme events while keeping tractability. We give a method based on Conditional Least Squares to estimate the parameters on daily data and estimate our model on eight major European cities. We then show how to calculate efficiently the average payoff of weather derivatives both by Monte-Carlo and Fourier transform techniques. This new model allows to better assess the risk related to temperature volatility.

Date: 2022-09, Revised 2023-08
New Economics Papers: this item is included in nep-ecm, nep-env and nep-rmg
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