Agriculture is one of the most weather sensitive industries and weatherrelated
risks are a major source of crop production risk exposure. One method of
hedging the risk exposure has been through the use of crop insurance. However, the
crop insurance market suffers from several problems of asymmetric information and
systemic weather risk. Without government subsidies or reinsurance crop insurers
would have to pass the cost of bearing the risk exposures to farmers. The rising cost
of the federal crop insurance program has been an incentive for the government to
seek alternative ways to reduce the cost.
Weather derivatives have been suggested as a potential risk management tool
to solve the problems. Previous studies have shown that weather derivatives are an
effective means of hedging agricultural production risk. Yet, it is unclear what role
weather derivatives will play as a risk management tool compared with the existing
federal crop insurance program. This study compares the hedging cost and
effectiveness of weather options with those of crop insurance for soybean and corn
production in four counties of southern Minnesota. We calculate weather option
premium by using daily simulation method and compare hedging effectiveness by
several risk indicators: certainty equivalence, risk premium, Sharpe ratio, and value at risk.
Our results show that the hedging effectiveness of using weather options is
limited at the farm level compared with crop insurance products. This is because
weather options insure against adverse weather events causing damage at the county
level, while crop insurance protects farmers against the loss of their crops directly at
the farm level as well as at the county level. Thus, individual farmers will continue to
use crop insurance with government subsidy for their production risk management. However, we observe that the hedging effectiveness of using weather options
increases as the level of spatial aggregation increases from farm level to county level
to four-county aggregate level. This implies that the government as a reinsurer can
reduce idiosyncratic yield risk by aggregating the individual risk exposures at the
county or higher level, and hedge the remaining systemic weather risk by purchasing
weather options in the financial market. As a result, weather derivatives could be used
by the government as a hedging tool to reduce the social cost of the federal crop
insurance program, since the government currently does not hedge their risk
exposures in the program.
Against our expectation based on the conventional wisdom, geographic basis
risk is not significant in hedging our local weather risk with non-local exchange
market weather options based on Minneapolis. It is likely due to the fact that the Midwest area including Minnesota has relatively homogeneous (or less variable)
weather conditions and crop yields across the counties compared to other U.S. regions.
The result indicates that we can hedge local weather risk with non-local exchange
market weather derivatives in southern Minnesota. However, it should be applied
cautiously to other locations, crops, or other types of weather derivatives, considering
spatial correlation of weather variables between a specific farm location and a weather
index reference point.
University of Minnesota Ph.D. dissertation. November 2011. Major: Applied Economics. Advisor: Glenn D. Pederson,. 1 computer file (PDF); ix, 197 pages, appendices I-IV.
Evaluating weather derivatives and crop insurance for farm production risk management in Southern Minnesota..
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