A1 Refereed original research article in a scientific journal
Hedging temperature risk with CDD and HDD temperature futures
Authors: Benth Fred Espen, Lempa Jukka
Publisher: WILEY
Publication year: 2023
Journal: Applied Stochastic Models in Business and Industry
Journal name in source: APPLIED STOCHASTIC MODELS IN BUSINESS AND INDUSTRY
Journal acronym: APPL STOCH MODEL BUS
Number of pages: 14
ISSN: 1524-1904
eISSN: 1526-4025
DOI: https://doi.org/10.1002/asmb.2815
Web address : https://doi.org/10.1002/asmb.2815
Self-archived copy’s web address: https://research.utu.fi/converis/portal/detail/Publication/180866756
This paper is concerned with managing risk exposure to temperature using weather derivatives. We consider hedging temperature risk using so-called HDD- and CDD-index futures, which are instruments written on temperatures in specific locations over specific time periods. The temperatures are modelled as continuous-time autoregressive (CARMA) processes and pricing of the hedging instrument is done under an equivalent pricing measure. We develop hedging strategies for locations, cutoff temperatures, and time periods different to the ones in the traded contracts, allowing for more flexibility in the hedging application. The dynamic hedging strategies are expressed explicitly by the term structure of the volatility. We also provide numerical case studies with temperatures following a CAR(3)-process to illustrate the temporal behaviour of the hedge under different scenarios.
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