Evaluating weather derivatives and crop insurance for farm production risk management in Southern Minnesota.

Abstract

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.