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Management of climate risks in agriculture-will weather derivatives permeate?

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  • Oliver Musshoff
  • Martin Odening
  • Wei Xu

Abstract

It is a matter of common knowledge that weather represents the major source of uncertainty in crop production. It is to be expected that weather fluctuations will increase in the future due to climate change. Traditionally, farmers tried to protect themselves against weather-related yield variations by buying insurances. More recently, there has been a discussion regarding the use of weather derivatives to safeguard against volumetric risks. Although weather derivatives display advantages over traditional insurances, there is only a relatively small market for these products in agriculture. This is partly attributed to the fact that it is unclear whether and to what extent weather derivatives are a useful instrument of risk management in agriculture. This study applies real yield and weather data from Northeast Germany in order to quantify the risk-reducing effect that can be achieved in wheat production by using precipitation options. To do so stochastic simulation is used. The hedging effectiveness is controlled by the contract design (index, strike level, tick size). However, the local basis risk and the geographical basis risk remain with the farmer. We separate both causes of basis risk and reveal the extent of each. This enables conclusions regarding the design of weather derivatives; thus the question dealt with here is relevant both for farmers and for potential sellers of weather derivatives.

Suggested Citation

  • Oliver Musshoff & Martin Odening & Wei Xu, 2009. "Management of climate risks in agriculture-will weather derivatives permeate?," Applied Economics, Taylor & Francis Journals, vol. 43(9), pages 1067-1077.
  • Handle: RePEc:taf:applec:v:43:y:2009:i:9:p:1067-1077
    DOI: 10.1080/00036840802600210
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    References listed on IDEAS

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    1. Manfredo, Mark R. & Richards, Timothy J., 2005. "Hedging Yield with Weather Derivatives: A Role for Options," 2005 Annual meeting, July 24-27, Providence, RI 19369, American Agricultural Economics Association (New Name 2008: Agricultural and Applied Economics Association).
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    Cited by:

    1. Robert Finger & Niklaus Lehmann, 2012. "The influence of direct payments on farmers’ hail insurance decisions," Agricultural Economics, International Association of Agricultural Economists, vol. 43(3), pages 343-354, May.
    2. Zhiwei Shen & Martin Odening, 2013. "Coping with systemic risk in index-based crop insurance," Agricultural Economics, International Association of Agricultural Economists, vol. 44(1), pages 1-13, January.
    3. Kapphan, Ines, 2011. "Weather insurance design with optimal hedging effectiveness," MPRA Paper 35861, University Library of Munich, Germany.
    4. von Davier, Zazie & Heyder, Matthias & Theuvsen, Ludwig, 2010. "Food Chain Actors’ Perceptions of and Adaptations to Volatile Markets: Results of a Media Analysis," 2010 Internatonal European Forum, February 8-12, 2010, Innsbruck-Igls, Austria 100472, International European Forum on Innovation and System Dynamics in Food Networks.
    5. Bokusheva, Raushan, 2010. "Measuring the dependence structure between yield and weather variables," MPRA Paper 22786, University Library of Munich, Germany.
    6. Ines Kapphan & Pierluigi Calanca & Annelie Holzkaemper, 2012. "Climate Change, Weather Insurance Design and Hedging Effectiveness," The Geneva Papers on Risk and Insurance - Issues and Practice, Palgrave Macmillan;The Geneva Association, vol. 37(2), pages 286-317, April.
    7. M. Ritter & O. Mußhoff & M. Odening, 2014. "Minimizing Geographical Basis Risk of Weather Derivatives Using A Multi-Site Rainfall Model," Computational Economics, Springer;Society for Computational Economics, vol. 44(1), pages 67-86, June.
    8. Raushan Bokusheva, 2011. "Measuring dependence in joint distributions of yield and weather variables," Agricultural Finance Review, Emerald Group Publishing, vol. 71(1), pages 120-141, May.
    9. Finger, Robert, 2012. "Biases in Farm-Level Yield Risk Analysis due to Data Aggregation," Journal of International Agricultural Trade and Development, Journal of International Agricultural Trade and Development, vol. 61(1).
    10. von Davier, Zazie & Heyder, Matthias & Theuvsen, Ludwig, 2010. "Media Analysis on Volatile Markets’ Dynamics and Adaptive Behavior for the Agri-Food System," International Journal on Food System Dynamics, International Center for Management, Communication, and Research, vol. 1(2).
    11. Finger, Robert & Lehmann, Niklaus, 2011. "Do Direct Payments Influence Farmers' Hail Insurance Decisions?," 2011 International Congress, August 30-September 2, 2011, Zurich, Switzerland 114355, European Association of Agricultural Economists.
    12. Filonov, Vitaly & Vedenov, Dmitry V., 2011. "Applications of copulas to Analysis of Efficiency of Weather Derivatives as Primary Crop Insurance Instruments," 2011 Annual Meeting, July 24-26, 2011, Pittsburgh, Pennsylvania 103972, Agricultural and Applied Economics Association.
    13. Finger, Robert, 2012. "How strong is the “natural hedge”? The effects of crop acreage and aggregation levels," 123rd Seminar, February 23-24, 2012, Dublin, Ireland 122538, European Association of Agricultural Economists.

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