WEATHER DERIVATIVES IN THE PRESENCE OF INDEX AND GEOGRAPHICAL BASIS RISK: HEDGING DAIRY PROFIT RISK

Gang Chen and Matthew C. Roberts

No 19030, 2004 Conference, April 19-20, 2004, St. Louis, Missouri from NCR-134 Conference on Applied Commodity Price Analysis, Forecasting, and Market Risk Management

Abstract: Weather conditions pose unique risks to dairy producers. Weather derivatives represent a potentially promising approach to augment dairy producers' risk management against adverse weather events. This study examines the effect of basis risk in weather derivatives, and whether the existence of basis risk mitigates the usefulness of weather derivatives for dairy risk management. Assuming a representative dairy producer has access to both weather derivatives and traditional heat abatement equipment, a closed-form solution for his/her optimal portfolio choice problem in the presence of basis risk is derived within a mean-variance utility framework. First-, second-, and third- degree stochastic dominance criteria are used to test the risk management effectiveness with less restrictive assumptions. Also proportional transaction costs are imposed on weather derivative prices calculated on the basis of actuarial fairness to allow the desirability of these contracts to their issuers.

Keywords: Marketing; Risk and Uncertainty (search for similar items in EconPapers)
Pages: 26
Date: 2004
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Citations: View citations in EconPapers (6)

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Persistent link: https://EconPapers.repec.org/RePEc:ags:ncrfou:19030

DOI: 10.22004/ag.econ.19030

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