A regime switching model for temperature modeling and applications to weather derivatives pricing (Q2299383)

The authors consider a Markov regime-switching model for temperature dynamics and apply the model to weather derivative pricing. The temperature dynamics is presented as \(T_t=\Lambda_t+Y_t\) where \(T_t\) is the temperature at time \(t\), \(\Lambda_t\) is the deterministic seasonal mean function, and \(Y_t\) is the deseasonalized temperature process which follows a Markov regime-switching model. A comparison with the existing models shows that the proposed model outperforms them 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. The temperature dynamics is relatively better represented compared to the existing models. As an illustration, prices of weather derivatives written on several temperature indices are derived.