The Effectiveness of Using a Basis Hedging Strategy to Mitigate the Financial Consequences of Weather-Related Risks

North American Actuarial Journal, v. 14 n. 2, p. 157-175, 2010

Posted: 25 Sep 2013

See all articles by Linda L. Golden

Linda L. Golden

University of Texas at Austin - Red McCombs School of Business

Charles C. Yang

Florida Atlantic University

Hong Zou

The University of Hong Kong - Faculty of Business and Economics

Date Written: August 18, 2009

Abstract

This paper examines the effectiveness of using a hedging strategy involving a basis derivative instrument to reduce the negative financial consequences of weather-related risks. We examine the effectiveness of using this basis derivative strategy for both summer and winter seasons, using both linear and nonlinear hedging instruments and the impacts of default risk and perception errors on weather hedging efficiency. We also compare the hedging effectiveness obtained using weather indices produced by both the Chicago Mercantile Exchange (CME) and Risk Management Solutions, Inc. (RMS). The results indicate that basis hedging is significantly more effective for the winter season than for the summer season, whether using the CME or RMS weather indices, and whether using linear or nonlinear derivative instruments. It is also found that the RMS regional weather indices are more effective than the CME weather indices, and the effectiveness of using either linear or nonlinear hedging instruments for weather risk management can vary significantly depending on the region of the country. In addition, the results indicate that default risk has some impact on nonlinear basis hedging efficiency but no impact on linear basis hedging efficiency, and reasonable perception errors on default risk have no impact on either linear or nonlinear basis hedging efficiency.

Keywords: default risk, basis risk, perception errors, weather risk management

JEL Classification: G12

Suggested Citation

Golden, Linda L. and Yang, Charles C. and Zou, Hong, The Effectiveness of Using a Basis Hedging Strategy to Mitigate the Financial Consequences of Weather-Related Risks (August 18, 2009). North American Actuarial Journal, v. 14 n. 2, p. 157-175, 2010, Available at SSRN: https://ssrn.com/abstract=2330342

Linda L. Golden

University of Texas at Austin - Red McCombs School of Business ( email )

Austin, TX 78712
United States

Charles C. Yang (Contact Author)

Florida Atlantic University ( email )

777 Glades Road
Boca Raton, FL 33431
United States

Hong Zou

The University of Hong Kong - Faculty of Business and Economics ( email )

China

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