Temperature Forecasting in the Concept of Weather Derivatives: A Comparison between Wavelet Networks and Genetic Programming

Abstract

The purpose of this study is to develop a model that accurately describes the dynamics of the daily average temperature in the context of weather derivatives pricing. More precisely we compare two state of the art algorithms, namely wavelet networks and genetic programming against the classic linear approaches widely using in the contexts of temperature derivative pricing. The accuracy of the valuation process depends on the accuracy of the temperature forecasts. Our proposed models were evaluated and compared in-sample and out-of-sample in various locations. Our findings suggest that the proposed nonlinear methods significantly outperform the alternative linear models and can be used for accurate weather derivative pricing. © Springer-Verlag Berlin Heidelberg 2013.