Basis risk and weather hedging effectiveness

Jason D. Woodward and Philip Garcia

Agricultural Finance Review, 2008, vol. 68, issue 1, pages 99-117

Abstract: Basis risk – the risk that payoffs of a hedging instrument do not correspond to the underlying exposures – is cited as a primary concern for implementing weather data, we investigate several dimensions of weather basis risk in the U.S. corn market. Results suggest that while geographic basis risk can be significant, it should not preclude the use of geographic cross-hedging, particularly with temperature as opposed to precipitation derivatives. Risk reduction is appreciable and the degree to which geographic basis risk impedes effective hedging diminishes as spatial aggregation in the risk exposure and hedging instrument increases.

Keywords: Basis risk; Hedging effectiveness; Spatial aggregation; Weather derivatives (search for similar items in EconPapers)
Date: 2008

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