Minimizing geographical basis risk of weather derivatives using a multi-site rainfall model
AbstractWeather 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.
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Bibliographic InfoPaper provided by European Association of Agricultural Economists in its series 123rd Seminar, February 23-24, 2012, Dublin, Ireland with number 122527.
Date of creation: 23 Feb 2012
Date of revision:
management; weather risk; regional diversification; portfolio weights; Risk and Uncertainty; G11; Q14; G32;
Find related papers by JEL classification:
- G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
- Q14 - Agricultural and Natural Resource Economics; Environmental and Ecological Economics - - Agriculture - - - Agricultural Finance
- G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill
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