Basis risk and hedging efficiency of weather derivatives

Purpose – The purpose of this paper is to examine empirically the basis risk and hedging efficiency of temperature‐indexed standardized weather derivatives in hedging weather risks in the US energy industry. Design/methodology/approach – Within the risk minimization framework, using power load and temperature data, this research analyzes both linear and nonlinear hedging strategies using the two most popular types of standardized indexes – city indexes and regional indexes. Findings – The results indicate that the city indexes and regional indexes are not consistently superior to each other and the regional indexes should be a good complement to the current exchange‐listed indexes. The results also document that the basis risk is sufficiently low for the diversified power producers serving the US Northeast or Mid‐Atlantic regions in both the summer and winter seasons and California in the summer season. However, the basis risk is very high for the diversified power producers serving California in hedging the weather risk in the winter season. More discrepancies are observed in the hedging efficiency among the power producers serving the Texas region. Originality/value – This research provides important implications about the survivability and superiority of current and proposed standardized weather contracts and the design of effective standardized weather derivatives for the extant and potential weather markets.