The Concept And Types Of Basis Risk In The Weather Derivatives Market

Weather derivatives, although present for more than 20 years now, still are an underrepresented area in scientific literature, particularly domestic. As hedging instruments against weather risk, they are used to reduce volatility or uncertainty of future cash flows. In addition to many advantages over alternative methods of weather hedge, weather derivatives are characterized by a significant basis risk which has proven to reduce their effectiveness and thus limit their wider application. The basis risk in the weather derivatives market is specific and complex. Since not all weather derivatives users face the same type of basis risk, a detailed understanding of this problem needs to be developed in order to create an adequate weather risk and basis risk management solution. The purpose of the paper is to explain in detail the concept and types of basis risk in the weather derivatives market, how and why it emerges, its impact on the effectiveness of weather derivatives and how to minimize it. The following scientific methods were used: the method of analysis, classification and descriptiveness, the combined method of arrangement and differences, the method of the common changes, the comparative method, and the methods of concretization, synthesis and generalization. The value of the paper is in providing comprehensive review of possible types of basis risk that weather derivatives users face with, as well as discussing possible ways of basis risk management. Scientific contribution of the paper consists in a single conclusion regarding the impact of the basis risk on the weather derivatives effectiveness, regardless of the sector in which weather derivatives are applied, outlined as a result of numerous research papers review.