IDEAS home Printed from https://ideas.repec.org/a/wly/apsmbi/v35y2019i3p704-716.html

Mean‐variance hedging with basis risk

Author

Listed:
  • Xiaole Xue
  • Jingong Zhang
  • Chengguo Weng

Abstract

Basis risk arises in a number of financial and insurance risk management problems when the hedging assets do not perfectly match the underlying asset in a hedging program. Notable examples in insurance include the hedging for longevity risks, weather index–based insurance products, variable annuities, etc. In the presence of basis risk, a perfect hedging is impossible, and in this paper, we adopt a mean‐variance criterion to strike a balance between the expected hedging error and its variability. Under a time‐dependent diffusion model setup, explicit optimal solutions are derived for the hedging target being either a European option or a forward contract. The solutions are obtained by a delicate application of the linear quadratic control theory, the method of backward stochastic differential equation, and Malliavin calculus. A numerical example is presented to illustrate our theoretical results and their interesting implications.

Suggested Citation

  • Xiaole Xue & Jingong Zhang & Chengguo Weng, 2019. "Mean‐variance hedging with basis risk," Applied Stochastic Models in Business and Industry, John Wiley & Sons, vol. 35(3), pages 704-716, May.
    • Handle: RePEc:wly:apsmbi:v:35:y:2019:i:3:p:704-716
    DOI: 10.1002/asmb.2380
    as

    Download full text from publisher

    File URL: https://doi.org/10.1002/asmb.2380
    Download Restriction: no
    File URL: https://libkey.io/10.1002/asmb.2380?utm_source=ideas
    LibKey link: if access is restricted and if your library uses this service, LibKey will redirect you to where you can use your library subscription to access this item
    ---><---

    References listed on IDEAS

    as
    1. Patrick L. Brockett & Mulong Wang & Chuanhou Yang, 2005. "Weather Derivatives and Weather Risk Management," Risk Management and Insurance Review, American Risk and Insurance Association, vol. 8(1), pages 127-140, March.
    Full references (including those not matched with items on IDEAS)

    Most related items

    These are the items that most often cite the same works as this one and are cited by the same works as this one.
    1. Bertrand, Jean-Louis & Brusset, Xavier & Fortin, Maxime, 2015. "Assessing and hedging the cost of unseasonal weather: Case of the apparel sector," European Journal of Operational Research, Elsevier, vol. 244(1), pages 261-276.
    2. KEVORCHIAN, Cristian & GAVRILESCU, Camelia & HURDUZEU, Gheorghe, 2013. "Qualitative Risk Coverage In Agriculture Through Derivative Financial Instruments Based On Selyaninov Indices," Studii Financiare (Financial Studies), Centre of Financial and Monetary Research "Victor Slavescu", vol. 17(3), pages 19-32.
    3. Sarkar, P. & Wahab, M.I.M. & Fang, L., 2023. "Weather rebate contracts for different risk attitudes of supply chain members," European Journal of Operational Research, Elsevier, vol. 311(1), pages 139-153.
    4. Zhang, Jinggong, 2024. "Blended insurance scheme: A synergistic conventional-index insurance mixture," Insurance: Mathematics and Economics, Elsevier, vol. 119(C), pages 93-105.
    5. Aurélien Alfonsi & Nerea Vadillo, 2023. "Risk valuation of quanto derivatives on temperature and electricity," Post-Print hal-04358505, HAL.
    6. Haruyoshi Ito & Jing Ai & Akihiko Ozawa, 2016. "Managing Weather Risks: The Case of J. League Soccer Teams in Japan," Journal of Risk & Insurance, The American Risk and Insurance Association, vol. 83(4), pages 877-912, December.
    7. Sarkar, P. & Wahab, M.I.M. & Fang, L., 2024. "Weather rebate sharing contract for enhancing supply chain performance," International Journal of Production Economics, Elsevier, vol. 272(C).
    8. Josef TAUŠER & Radek ČAJKA, 2014. "Weather derivatives and hedging the weather risks," Agricultural Economics, Czech Academy of Agricultural Sciences, vol. 60(7), pages 309-313.
    9. Simona Franzoni & Cristian Pelizzari, 2021. "Rainfall option impact on profits of the hospitality industry through scenario correlation and copulas," Annals of Operations Research, Springer, vol. 299(1), pages 939-962, April.
    10. Boyle, Colin F.H. & Haas, Jannik & Kern, Jordan D., 2021. "Development of an irradiance-based weather derivative to hedge cloud risk for solar energy systems," Renewable Energy, Elsevier, vol. 164(C), pages 1230-1243.
    11. Woodard, Joshua D. & Garcia, Philip, 2008. "Weather Derivatives, Spatial Aggregation, and Systemic Risk: Implications for Reinsurance Hedging," Journal of Agricultural and Resource Economics, Western Agricultural Economics Association, vol. 33(01), pages 1-18, April.
    12. Miguel, Fusco & Dario, Bacchini & Esteban Otto, Thomasz, 2014. "Riesgo Agropecuario: Incidencia Económica e Innovaciones para su mitigación. El caso de Argentina [Agricultural Risk Managment: Economic Incidence and Mitigation Innovations. The Case of Argentina]," MPRA Paper 56408, University Library of Munich, Germany.
    13. Banerjee, Chirantan & Berg, Ernst, 2011. "Efficiency Of Wind Indexed Typhoon Insurance For Rice," 2011 International Congress, August 30-September 2, 2011, Zurich, Switzerland 114240, European Association of Agricultural Economists.
    14. Zura Kakushadze & Juan Andrés Serur, 2018. "151 Trading Strategies," Springer Books, Springer, number 978-3-030-02792-6, March.
    15. Yuji Yamada & Takuji Matsumoto, 2023. "Construction of Mixed Derivatives Strategy for Wind Power Producers," Energies, MDPI, vol. 16(9), pages 1-26, April.
    16. Zhang, Jingong & Tan, Ken Seng & Weng, Chengguo, 2017. "Optimal hedging with basis risk under mean–variance criterion," Insurance: Mathematics and Economics, Elsevier, vol. 75(C), pages 1-15.
    17. Gheorghe HURDUZEU & C?t?lin HUIDUMAC & Raluca HURDUZEU, 2014. "The Most Important Agri-Culture Risk. The Risk Culture," Proceedings of the INTERNATIONAL MANAGEMENT CONFERENCE, Faculty of Management, Academy of Economic Studies, Bucharest, Romania, vol. 8(1), pages 413-418, November.
    18. Joshua D. Woodard & Philip Garcia, 2008. "Basis risk and weather hedging effectiveness," Agricultural Finance Review, Emerald Group Publishing Limited, vol. 68(1), pages 99-117, May.
    19. Makkonen, Adam & Vallström, Daniel & Uddin, Gazi Salah & Rahman, Md Lutfur & Haddad, Michel Ferreira Cardia, 2021. "The effect of temperature anomaly and macroeconomic fundamentals on agricultural commodity futures returns," Energy Economics, Elsevier, vol. 100(C).
    20. Jean-Louis Bertrand & Xavier Brusset, 2018. "Managing the financial consequences of weather variability," Journal of Asset Management, Palgrave Macmillan, vol. 19(5), pages 301-315, September.

    More about this item

    Statistics

    Access and download statistics

    Corrections

    All material on this site has been provided by the respective publishers and authors. You can help correct errors and omissions. When requesting a correction, please mention this item's handle: RePEc:wly:apsmbi:v:35:y:2019:i:3:p:704-716. See general information about how to correct material in RePEc.

    If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

    If CitEc recognized a bibliographic reference but did not link an item in RePEc to it, you can help with this form .

    If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your RePEc Author Service profile, as there may be some citations waiting for confirmation.

    For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: Wiley Content Delivery (email available below). General contact details of provider: https://doi.org/10.1002/(ISSN)1526-4025 .

    Please note that corrections may take a couple of weeks to filter through the various RePEc services.

    IDEAS is a RePEc service. RePEc uses bibliographic data supplied by the respective publishers.