Is temperature-index derivative suitable for China?

In this paper, we assessed the suitability of temperature derivatives for China through modeling. We assumed that if the physical dynamics of temperature of some cities are identical, then the same types of temperature derivatives can be used in these cities. Nearly twenty years temperature data of forty-seven cities with traded temperature derivatives on the Chicago Mercantile Exchange Group (CME) and seven Chinese cities were collected and analyzed in a two-step approach. Firstly, the AR-EGARCH model capturing the shock asymmetry of the volatility of temperature is used to simulate the dynamics of temperature of the cities. Secondly, the temperature of the cities are classified through cluster analysis based on model parameters from the AR-EGARCH model. The results showed that the fitting effect of the AR-EGARCH model is very good, and only a few cities did not display the shock asymmetry. The model for Nanjing fitted well into one of the categories of the cities in the CME; but the other six Chinese cities belong to new categories, which are different from the cities in the CME. We concluded that HDD and CAT in Europe and CAT ∗ in Japan can be used directly in Nanjing, but the existing temperature derivatives in CME were unsuitable for the other six Chinese cities. Recommendations for the establishment of weather derivatives market in China have been proposed. • We explored whether temperature derivatives traded on CME are suitable to China. • Cluster analysis in form of model parameters from the AR-EGARCH model is used to classify temperature data. • Asymmetry of the volatility of the temperature is confirmed according to the AR-EGARCH model. • HDD and CAT in Europe and CAT ∗ in Japan can be used directly in Nanjing of China. [ABSTRACT FROM AUTHOR]