《Wavelet Analysis and Weather Derivatives Pricing》.pdf

Wavelet Analysis and Weather Derivatives Pricing Achilleas Zapranis1, Antonis Alexandridis2 Abstract. In this paper, we use wavelet analysis to localize in Paris, France, a mean-reverting Ornstein-Uhlenbeck process with seasonality in the level and volatility. Wavelet analysis is an extension of the Fourier transform, which is very well suited to the analysis of non-stationary signals. We use wavelet analysis to identify the seasonality component in the temperature process as well as in the volatility of the temperature anomalies (residuals). Our model is validated on more than 100 years of data collected from Paris, one of the European cities traded at Chicago Mercantile Exchange. We also study the effect of replacing the original AR(1) process with ARMA, ARFIMA and ARFIMA-FIGARCH models, and the impact of the temperature outliers on the normality of the temperature anomalies. Keywords : Weather Derivatives, W avelet Analysi s, Temper ature Dyn amic Mod- eling, AR , ARMA , ARFIMA , FIGARCH , CAT Option s, Di screte Pricing Model s. JEL Classification : C5 1, G 13, Q54 1 Corresponding Author: Assistant Professor, Department of Accounting and Finance, University of Macedonia, 156 Egnatia St., 54006 Thessaloniki, Greece (email: zapranis@uom.gr). 2 PhD Candidate, Department of Accounting and Finance, University of Macedonia, 156 Egnatia St., 54006 Thessaloniki, Greece (email: aalex @uom.gr). 1 1. Introduction Since their inception in 1996, weather derivatives have known a substantial growth. The first parties to arrange for, and issue weather derivatives in 1996, were energy companies, which after the deregulation of energy markets were exposed to weather risk. In September 1999, the Chicago Mercantile Exchange (CME) launched the first exchange trad