Minimizing geographical basis risk of weather derivatives using a multi-site rainfall model

Matthias Ritter, Oliver Musshoff and Martin Odening

No 122527, 123rd Seminar, February 23-24, 2012, Dublin, Ireland from European Association of Agricultural Economists

Abstract: Weather risk is one of the main causes for income fluctuation in agriculture. Since 1997, the economic consequences of weather risk can be insured with weather derivatives, which are offered for many different weather events, such as temperature, rainfall, snow or hurricanes. It is well known that the hedging effectiveness of weather derivatives is interfered by the existence of geographical basis risk, i.e., the deviation of weather conditions at different locations. In this paper, we explore how geographical basis risk of rainfall based derivatives can be reduced by regional diversification. Minimizing geographical basis risk requires knowledge of the joint distribution of rainfall at different locations. For that purpose, we estimate a daily multi-site rainfall model from which optimal portfolio weights are derived. We find that this method allows to reduce geographical basis risk more efficiently than simpler approaches as, for example, inverse distance weighting.

Keywords: Risk; and; Uncertainty (search for similar items in EconPapers)
Pages: 20
Date: 2012-02-23
New Economics Papers: this item is included in nep-agr
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Citations: View citations in EconPapers (3)

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Related works:
Journal Article: Minimizing Geographical Basis Risk of Weather Derivatives Using A Multi-Site Rainfall Model (2014)
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Persistent link: https://EconPapers.repec.org/RePEc:ags:eaa123:122527

DOI: 10.22004/ag.econ.122527

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