Management of Climate Risks in Agriculture - Will Weather Derivatives Permeate?

Abstract

It is a matter of common knowledge that weather represents the major source of uncertainty in crop production. It is to be expected that weather fluctuations will increase in the future due to climate change. More recently, there has been a discussion regarding the use of weather derivatives to safeguard against volumetric risks. Although weather derivatives display advantages over traditional insurances, there is only a relatively small market for these products in agriculture. This is partly attributed to the fact that it is unclear whether and to what extent weather derivatives are a useful instrument of risk management in agriculture. This study ap-plies real yield and weather data from northeast Germany in order to quantify the risk-reducing effect that can be achieved in wheat production by using precipitation options. To do so stochas-tic simulation is used. The hedging effectiveness is controlled by the contract design (index, strike level, tick size). However, the local basis risk and the geographical basis risk remain with the farmer. We separate both causes of basis risk and reveal the extent of each. This enables conclusions regarding the design of weather derivatives; thus the question dealt with here is relevant both for farmers and for potential sellers of weather derivatives.