Author(s)

M.B. Rohrer

Abstract

The relevance of basis risk of financial instruments for hedging business risks differs largely. In the case of weather derivatives it can be shown that in particular location basis risk can reach critical levels for the hedging company in some cases. However, basis risk is rarely considered in the weather derivatives market today. Often the hedger’s counterpart is arguing with high correlation coefficient between offered index station and hedged location. But it can be shown that for the hedger the distribution of residuals is in most cases more important than the correlation coefficient. Product and time basis risk can be important in some cases too. It is concluded that consideration of basis risk in weather derivatives market enlarges acceptance of these instruments. In this respect, proper assessment of the basis risk for a weather hedge is important for all players in this marke

Keywords