Minimizing Geographical Basis Risk of Weather Derivatives Using A Multi-Site Rainfall Model
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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.
KeywordsRisk management Weather risk Regional diversification Portfolio weights
The financial support from the German Research Foundation via the CRC 649 ‘Economic Risk’, Humboldt-University Berlin, is gratefully acknowledged. Moreover, the authors would like to thank the participants of the CRC 649 Conference 2011 for their helpful comments and discussions on this topic.
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