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Exploring the financial risk of a temperature index: a fractional integrated approach

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Abstract

This paper introduces a new temperature index, which can suitably represent the underlying of a weather derivative. Such an index is defined as the weighted mean of daily average temperatures measured in different locations. It may be used to hedge volumetric risk, that is the effect of unexpected fluctuations in the demand/supply for some specific commodities—of agricultural or energy type, for example—due to unfavorable temperature conditions. We aim at exploring the long term memory property of the volatility of such an index, in order to assess whether there exist some long-run paths and regularities in its riskiness. The theoretical part of the paper proceeds in a stepwise form: first, the daily average temperatures are modeled through autoregressive dynamics with seasonality in mean and volatility; second, the assessment of the distributional hypotheses on the parameters of the model is carried out for analyzing the long term memory property of the volatility of the index. The theoretical results suggest that the single terms of the index drive the long memory of the overall aggregation; moreover, interestingly, the proper selection of the parameters of the model might lead both to cases of persistence and antipersistence. The applied part of the paper provides some insights on the behaviour of the volatility of the proposed index, which is built starting from single daily average temperature time series.

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Acknowledgements

The authors thank Dr. Ing. R. de Kok for fruitful management of data.

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Authors and Affiliations

  1. Department of Law and Econommics, University of Roma Unitelma-Sapienza, V.le Regina Elena 295, 00161, Rome, Italy

    Rosella Castellano

  2. Department of Economics and Law, University of Macerata, Via Crescimbeni 20, 62100, Macerata, Italy

    Roy Cerqueti

  3. Department of Statistical Sciences, Sapienza University of Rome, p.le A. Moro 5, 00185, Rome, Italy

    Giulia Rotundo

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  1. Rosella Castellano
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Correspondence to Rosella Castellano.

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Castellano, R., Cerqueti, R. & Rotundo, G. Exploring the financial risk of a temperature index: a fractional integrated approach. Ann Oper Res 284, 225–242 (2020). https://doi.org/10.1007/s10479-018-3063-0

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