Basis risk – the risk that payoffs of a hedging instrument do not correspond to the underlying exposures – is cited as a primary concern for implementing weather data, we investigate several dimensions of weather basis risk in the U.S. corn market. Results suggest that while geographic basis risk can be significant, it should not preclude the use of geographic cross‐hedging, particularly with temperature as opposed to precipitation derivatives. Risk reduction is appreciable and the degree to which geographic basis risk impedes effective hedging diminishes as spatial aggregation in the risk exposure and hedging instrument increases.
Agricultural Finance Review – Emerald Publishing
Published: May 5, 2008
Keywords: Basis risk; Hedging effectiveness; Spatial aggregation; Weather derivatives