Managing Dairy Profit Risk Using Weather Derivatives

Weather conditions are the primary dairy production risk. Hot and humid weather induces heat stress, which reduces both the quantity and quality of milk production. Traditional heat abatement technologies control the environment through ventilation, misting or evaporative cooling. Usually, they can increase the producers' expected profit, but cannot cover all the profit losses from heat stress. Weather derivatives could reduce weather-induced profit risk and thus act as a substitute for traditional abatement technologies in the aspect of risk management. We test the risk management value of weather derivatives in a utility maximization framework. The result is that weather derivatives offer an opportunity to improve the efficient portfolio frontier, and simultaneously using weather derivatives and abatement equipment is more favorable than using each of them alone.