Browsing by Subject "Basis Risk"

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    Evaluating weather derivatives and crop insurance for farm production risk management in Southern Minnesota.
    (2011-11) Chung, Wonho
    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.
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    Quantifying Impacts of Class I Milk Price Formula Reform: A Study of FMMO Uniform Milk Price Volatility and Class I Milk Hedging
    (2019-08) Clark, Jordan
    Up until the enactment of the 2018 Farm Bill (“Agricultural Improvement Act of 2018”), available CME futures contracts did not consistently converge to costs paid by manufacturers of packaged milk. Due to the lack of convergence, CME dairy futures were inadequate risk management tools for the packaged milk industry. Seeking to increase convergence between the available CME futures contracts and underlying costs in the packaged milk industry, dairy trade organizations proposed a reformed pricing formula in 2017, which was ultimately included in the 2018 Farm Bill and enacted beginning with the May 2019 Class I milk price. The newly reformed formula was designed to strengthen the price relationship between available CME futures contracts and Advanced Class I skim milk prices without having a long-term directional influence on average Advanced Class I skim milk prices paid by packaged milk manufacturers or milk producer pay prices. This study quantifies the impact that the newly reformed pricing formula would have had on milk producer pay prices between 2000 and 2017 – the period that informed the design of the new pricing formula. This is the first study to quantify how the change of the pricing formula would have affected producer pay prices in different regions and the first to identify optimal hedging ratios of the reformed pricing formula. We find that between January 2000 to December 2017, average uniform prices for each federal milk marketing order would have differed by less than $0.01/cwt when comparing the previous and current Class I pricing formulas. We also find that that uniform prices are more volatile in federal milk marketing orders with the highest Class I utilizations and, had the newly reformed pricing formula been in place, would have reduced volatility in all FMMOs between 2000 and 2017. We also find that the basis risk of varying hedging strategies is significantly reduced under the reformed formula as compared to the previous formula. Furthermore, we identify optimal hedge ratios for the reformed Class I formulas.