Hedging with weather derivatives: a role for options in reducing basis risk

Weather derivatives represent an important financial innovation for risk management. As with the use of any derivatives contract, the behaviour of the basis ultimately determines the net-hedged outcome. However, when using weather derivatives to hedge volumetric risks, risk managers often face unique basis risks arising from both the choice of weather station where a derivatives contract is written, as well as the relationship between the hedged volume and the underlying weather index. Using the encompassing principle, this research shows that the nonlinear relationship often found between crop yields and weather creates a specific hedging role for options. The results suggest that weather derivative instruments with nonlinear pay-offs, such as options, be used solely or in combination with linear payoff instruments, such as swaps or futures, to minimize basis risk associated with the nonlinear relationship between yields and weather. This research also suggests that the choice of weather station may be less critical in managing basis risk than properly accounting for the relationship between yields and weather.