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CONSISTENT FACTOR MODELS FOR TEMPERATURE MARKETS

    https://doi.org/10.1142/S0219024912500276Cited by:10 (Source: Crossref)

    We propose an approach for pricing and hedging weather derivatives based on including forward looking information about the temperature available to the market. This is achieved by modeling temperature forecasts by a finite dimensional factor model. Temperature dynamics are then inferred in the short end. In analogy to interest rate theory, we establish conditions which guarantee consistency of a factor model with the martingale dynamics of temperature forecasts. Finally, we consider a specific two-factor model and examine in more detail pricing and hedging of weather derivatives in this context.