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Minimizing Geographical Basis Risk of Weather Derivatives Using A Multi-Site Rainfall Model

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  • M. Ritter
  • O. Mußhoff
  • M. Odening

Abstract

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. Copyright Springer Science+Business Media New York 2014

Suggested Citation

  • M. Ritter & O. Mußhoff & M. Odening, 2014. "Minimizing Geographical Basis Risk of Weather Derivatives Using A Multi-Site Rainfall Model," Computational Economics, Springer;Society for Computational Economics, vol. 44(1), pages 67-86, June.
    • Handle: RePEc:kap:compec:v:44:y:2014:i:1:p:67-86
    DOI: 10.1007/s10614-013-9410-y
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    Citations

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    Cited by:

    1. Goodrich, Brittney K. & Davidson, Kelly A., 2024. "Enrollment in Pasture, Rangeland, and Forage Rainfall Index Insurance: Awareness Matters," Journal of Agricultural and Resource Economics, Western Agricultural Economics Association, vol. 0(Preprint), January.
    2. Xiaofeng Cao & Ostap Okhrin & Martin Odening & Matthias Ritter, 2015. "Modelling spatio-temporal variability of temperature," Computational Statistics, Springer, vol. 30(3), pages 745-766, September.
    3. Brenda López Cabrera & Martin Odening & Matthias Ritter, 2013. "Pricing Rainfall Derivatives at the CME," SFB 649 Discussion Papers SFB649DP2013-005, Sonderforschungsbereich 649, Humboldt University, Berlin, Germany.
    4. Ceballos, Francisco, 2016. "Estimating spatial basis risk in rainfall index insurance: Methodology and application to excess rainfall insurance in Uruguay," IFPRI discussion papers 1595, International Food Policy Research Institute (IFPRI).
    5. Doms, Juliane, 2017. "Put, call or strangle? About the challenges in designing weather index insurances to hedge performance risk in agriculture," 57th Annual Conference, Weihenstephan, Germany, September 13-15, 2017 261990, German Association of Agricultural Economists (GEWISOLA).
    6. López Cabrera, Brenda & Odening, Martin & Ritter, Matthias, 2013. "Pricing rainfall futures at the CME," Journal of Banking & Finance, Elsevier, vol. 37(11), pages 4286-4298.
    7. Schmidt, Lorenz & Odening, Martin & Schlanstein, Johann & Ritter, Matthias, 2022. "Exploring the weather-yield nexus with artificial neural networks," Agricultural Systems, Elsevier, vol. 196(C).

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    More about this item

    Keywords

    Risk management; Weather risk; Regional diversification; Portfolio weights;
    All these keywords.

    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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