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Zbl 1142.91575
Zapranis, A.; Alexandridis, A.
Modelling the temperature time-dependent speed of mean reversion in the context of weather derivatives pricing. (English)
[J] Appl. Math. Finance 15, No. 3-4, 355-386 (2008). ISSN 1350-486X

Summary: In the context of an Ornstein-Uhlenbeck temperature process, we use neural networks to examine the time dependence of the speed of the mean reversion parameter $\alpha$ of the process. We estimate non-parametrically with a neural network a model of the temperature process and then compute the derivative of the network output w.r.t. the network input, in order to obtain a series of daily values for $\alpha$. To our knowledge, this is the first time that this has been done, and it gives us a much better insight into the temperature dynamics and temperature derivative pricing. Our results indicate strong time dependence in the daily values of $\alpha$, and no seasonal patterns. This is important, since in all relevant studies performed thus far, $\alpha$ was assumed to be constant. Furthermore, the residuals of the neural network provide a better fit to the normal distribution when compared with the residuals of the classic linear models used in the context of temperature modelling (where $\alpha$ is constant). It follows that by setting the mean reversion parameter to be a function of time we improve the accuracy of the pricing of the temperature derivatives. Finally, we provide the pricing equations for temperature futures, when $\alpha$ is time dependent.

MSC 2000:: *91B28 Finance etc.
91B24 Price theory and market structure
60K35 Interacting random processes
92B20 General theory of neural networks
86A10 Meteorology

Keywords: neural networks; weather derivatives pricing

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Zentralblatt MATH Berlin [Germany]