A Levy Regime-Switching Temperature Dynamics Model for Weather Derivatives

Samuel Gyamerah (saasgyam@gmail.com), Philip Ngare and Dennis Ikpe

MPRA Paper from University Library of Munich, Germany

Abstract: Weather is a key production factor in agricultural crop production and at the same time the most significant and least controllable source of peril in agriculture. These effects of weather on agricultural crop production have triggered a widespread support for weather derivatives as a means of mitigating the risk associated with climate change on agriculture. However, these products are faced with basis risk as a result of poor design and modelling of the underlying weather variable (temperature). In order to circumvent these problems, a novel time-varying mean-reversion L´evy regime-switching model is used to model the dynamics of the deseasonalized temperature dynamics. Using plots and test statistics, it is observed that the residuals of the deseasonalized temperature data are not normally distributed. To model the nonnormality in the residuals, we propose using the hyperbolic distribution to capture the semiheavy tails and skewness in the empirical distributions of the residuals for the shifted regime. The proposed regime-switching model has a mean-reverting heteroskedastic process in the base regime and a Levy process in the shifted regime. By using the Expectation-Maximization algorithm, the parameters of the proposed model are estimated. The proposed model is flexible as it modelled the deseasonalized temperature data accurately.

Keywords: Levy Process; Weather Derivative; Temperature; Regime-Switching (search for similar items in EconPapers)
JEL-codes: C44 C53 C55 Q5 Q54 (search for similar items in EconPapers)
Date: 2018-05-14, Revised 2018-07-10
New Economics Papers: this item is included in nep-agr and nep-env
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Published in International Journal of Stochastic Analysis 8534131.2018(2018): pp. 1-16

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