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

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.