Hedging crop yield with exchange-traded weather derivatives

Rui Zhou, Johnny Siu-Hang Li and Jeffrey Pai

Agricultural Finance Review, 2016, vol. 76, issue 1, 172-186

Abstract: Purpose - – The application of weather derivatives in hedging crop yield risk is gaining more interest. However, the further development of weather derivatives – particularly exchange-traded – in the agricultural sector has been impeded by concerns over their hedging performance. The purpose of this paper is to develop a new framework to derive the optimal hedging strategy and evaluate hedging effectiveness. Design/methodology/approach - – This framework incorporates a stochastic temperature model, a crop yield model, a risk-neutral pricing method and a profit optimization procedure. Based on a large number of simulated scenarios, the authors study crop yield hedge for a future year. The authors allow the hedger to choose from different types of exchange-traded weather derivatives, and examine the impact of various factors on the optimal hedging strategy. Findings - – The analysis shows that hedging objective, pricing method and geographical location of the hedged exposure all play important roles in choosing the best hedging strategy and assessing hedging effectiveness. Originality/value - – This framework is forward-looking, because it focusses on the crop yield hedge for a future year rather than on the historical hedging effectiveness often studied in literature. It utilizes the most up-to-date information related to temperature and crop yield, and hence produces a hedging strategy which is more relevant to the year under consideration.

Keywords: Crop yield; Filtered historical simulation; Geographical basis risk; Hedging effectiveness; Spatial aggregation effect; Weather derivative (search for similar items in EconPapers)
Date: 2016
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Persistent link: https://EconPapers.repec.org/RePEc:eme:afrpps:v:76:y:2016:i:1:p:172-186

DOI: 10.1108/AFR-11-2015-0045

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