Vol. 77 No. 2 (2022)
Research Articles

Weather Risk Management in Agriculture Using Weather Derivatives

Martina Bobrikova
Department of Finance, Faculty of Economics, Technical University of Košice

Published 2022-08-04

Keywords

  • weather risk management,
  • weather option,
  • rainfall index,
  • burn analysis,
  • hedging efficiency

How to Cite

Bobrikova, M. (2022). Weather Risk Management in Agriculture Using Weather Derivatives. Italian Review of Agricultural Economics (REA), 77(2), 15–26. https://doi.org/10.36253/rea-13416

Abstract

The purpose of this paper is to examine weather risk management by application of weather derivatives in agriculture and evaluate the hedging efficiency. Agriculture is a sector highly sensitive to meteorological elements that affect the yield of many crops. The underlying weather indices depending on temperature, rainfall and wind speed are analysed. Pricing follows the index modelling method using the Burn analysis valuation for fair premium calculation. The proposal of hedging strategies against excess rainfall in the crop cycle using weather options for Kosice region in the east of Slovakia is investigated and discussed. Results show that the weather derivatives application in weather risk management reduced the yield volatility in agriculture.

Downloads

Download data is not yet available.

Metrics

Metrics Loading ...

References

  1. Alaton P., Djehiche B., Stillberger D. (2002). On modelling and pricing weather derivatives. Applied Mathematical Finance, 9(1): 1-20. DOI: 10.1080/13504860210132897
  2. Alexandridis G., Mavrovitis Ch.F., Travlos N.G. (2012). How have M&As changed? Evidence from the sixth merger wave. The European Journal of Finance, 18(8): 663-688. DOI: 10.1080/1351847X.2011.628401
  3. Alexandridis A.K., Zapranis A.D. (2013a). Weather Derivatives. New York: Springer.
  4. Alexandridis A.K., Zapranis A.D. (2013b). Wind derivatives: Modeling and pricing. Computational Economics, 41(3): 299-326. DOI: 10.1007/s10614-012-9350-y
  5. Bartkowiak M. (2009). Weather derivatives. Mathematics in Economics, 5-17.
  6. Bemš J., Aydin C. (2021). Introduction to weather derivatives. Wiley Interdisciplinary Reviews: Energy and Environment. DOI: 10.1002/wene.426
  7. Benth F.E. (2003). On arbitrage-free pricing of weather derivatives based on fractional Brownian motion. Applied Mathematical Finance, 10(4): 303-324. DOI: 10.1080/1350486032000174628
  8. Benth F.E., Benth J.Š. (2005). Stochastic modelling of temperature variations with a view towards weather derivatives. Applied Mathematical Finance, 12(1): 53-85. DOI: 10.1080/1350486042000271638
  9. Benth F.E., Benth J.Š. (2007). The volatility of temperature and pricing of weather derivatives. Quantitative Finance, 7(5): 553-561. DOI: 10.1080/14697680601155334
  10. Benth F.E. (2011). The stochastic volatility model of Barndorff‐Nielsen and Shephard in commodity markets. Mathematical Finance: An International Journal of Mathematics, Statistics and Financial Economics, 21(4): 595-625. DOI: 10.1111/j.1467-9965.2010.00445.x
  11. Benth F.E., Benth J.Š. (2011). Weather derivatives and stochastic modelling of temperature. International Journal of Stochastic Analysis, (4). DOI: 10.1155/2011/576791.
  12. Berg E., Schmitz B., Starp M., Trenkel H. (2006). Weather Derivatives as a Risk Management Tool in Agriculture. In: Cafiero, C. und Cioffi, A. (eds.): Income Stabilization in Agriculture. The Role of Public Policies, Proceedings of the 86th EAAE Seminar AFarm Income Stabilization: What role should public policy play? Anacapri, Italy, Ototber 21-22, 2004, Edizioni Scientifiche Italiane s.p.a., Neapel and Rom, pp. 379-396.
  13. Bobriková M. (2016). Weather risk management in agriculture. Acta Universitatis Agriculturae et Silviculturae Mendelianae Brunensis, 64(4): 1303-1309. DOI: 10.11118/actaun201664041303
  14. Bobriková M. (2021). Price risk management in the wheat market using option strategies. Economics of Agriculture, 68(2): 449-461. DOI: 10.5937/ekoPolj2102449B
  15. Brockett P.L., Wang M., Yang C. (2005). Weather derivatives and weather risk management. Risk Management and Insurance Review, 8: 127-139. DOI: 10.1111/j.1540-6296.2005.00052.x
  16. Brody D.C., Syroka J., Zervos M. (2002). Dynamical pricing of weather derivatives. Quantitative Finance, 2(3): 189. DOI: 10.1088/1469-7688/2/3/302
  17. Cantelaube P., Terres J.M. (2005). Seasonal weather forecasts for crop yield modelling in Europe. Tellus A: Dynamic Meteorology and Oceanography, 57(3): 476-487. DOI: 10.3402/tellusa.v57i3.14669
  18. Cao M., Wei J. (2004). Weather derivatives valuation and market price of weather risk. Journal of Futures Markets: Futures, Options, and Other Derivative Products, 24(11): 1065-1089. DOI: 10.1002/fut.20122
  19. Cramer S., Kampouridis M., Freitas A.A., Alexandridis A. (2019). Stochastic model genetic programming: Deriving pricing equations for rainfall weather derivatives. Swarm and Evolutionary Computation, 46: 184-200. DOI: 10.1016/j.swevo.2019.01.008
  20. Cui K., Swishchuk A.V. (2015). Applications of weather derivatives in the energy market. Journal of Energy Markets, 8(1): 1-18. DOI: 10.21314/JEM.2015.132
  21. Cyr D., Kusy M., Shaw A.B. (2010). Climate change and the potential use of weather derivatives to hedge vineyard harvest rainfall risk in the Niagara region. Journal of Wine Research, 21(2): 207-227. DOI: 10.1080/09571264.2010.530112
  22. Davis M. (2001). Pricing weather derivatives by marginal value. Quantitative Finance, 1(3): 305-308. DOI: 10.1080/713665730
  23. De Castro P., Adinolfi F., Capitanio F., Di Falco S., & Di Mambro A. (2012). The Politics of Land and Food Scarcity, Routledge - Earthscan, Taylor & Francis Group Ltd, Oxford (UK), p. 168.
  24. Deng X., Barnett B.J., Vedenov D.V., West J.W. (2007). Hedging dairy production losses using weather‐based index insurance. Agricultural Economics, 36(2): 271-280. DOI: 10.1111/j.1574-0862.2007.00204.x
  25. Di Falco S., Bozzola M., Adinolfi F., Capitanio F. (2014). Crop insurance as a strategy for adapting to climate change. Journal of Agricultural Economics, 65(2): 485-504. DOI: 10.1111/1477-9552.12053.
  26. Ender M., Zhang R. (2015). Efficiency of weather derivatives for Chinese agriculture industry. China Agricultural Economic Review, 7(1): 102-121. DOI: 10.1108/CAER-06-2013-0089
  27. Hess U., Richter K., Stoppa A. (2002). Weather risk management for agriculture and agri-business in developing countries. Climate Risk and the Weather Market, Financial Risk Management with Weather Hedges. London: Risk Books.
  28. Heston S.L. (1993). A closed-form solution for options with stochastic volatility with applications to bond and currency options. The Review of Financial Studies, 6(2): 327-343. DOI: 10.1093/rfs/6.2.327
  29. Chavas J.P., Di Falco S., Adinolfi F., Capitanio F. (2019). Weather effects and their long-term impact on the distribution of agricultural yields: evidence from Italy. European Review of Agricultural Economics, 46(1): 29-51. DOI: 10.1093/erae/jby019
  30. Chen G., Roberts M.C., Thraen C.S. (2006). Managing dairy profit risk using weather derivatives. Journal of Agricultural and Resource Economics, 31(3): 653-666. DOI: 10.22004/ag.econ.8624
  31. Jewson S., Brix A. (2005). Weather derivative valuation: the meteorological, statistical, financial and mathematical foundations. Cambridge University Press.
  32. Leggio K.B. (2007). Using weather derivatives to hedge precipitation exposure. Managerial Finance, 33(4): 246-252. Emerald Group Publishing Ltd.
  33. Markovic T., Jovanovic M. (2011). Risk management in plant production with weather derivatives. Contemporary Agriculture, 60: 1-6.
  34. Matsumoto T., Yamada Y. (2021). Simultaneous hedging strategy for price and volume risks in electricity businesses using energy and weather derivatives. Energy Economics, 95 (3), 105101. DOI: 10.1016/j.eneco.2021.105101
  35. Musshoff O., Odening M., Xu W. (2011). Management of climate risks in agriculture – will weather derivatives permeate? Applied Economics, 43(9): 1067-1077. DOI: 10.1080/00036840802600210
  36. Müller A., Grandi M. (2000). Weather derivatives: a risk management tool for weather-sensitive industries. The Geneva Papers on Risk and Insurance. Issues and Practice, 25(2): 273-287. DOI: 10.1111/1468-0440.00065
  37. Raucci G.L., Lanna R., da Silveira F., Capitani D.H.D. (2019). Development of weather derivatives: evidence from the Brazilian soybean market. Italian Review of Agricultural Economics, 74(2): 17-28. DOI: 10.13128/rea-10850
  38. Richards T.J., Manfredo M.R., Sanders D.R. (2004). Pricing weather derivatives. American Journal of Agricultural Economics, 86(4): 1005-1017. DOI: 10.1111/j.0002-9092.2004.00649.x
  39. Rusnáková M. (2015). Commodity price risk management using option strategies. Agricultural Economics, 61(4): 149-157. DOI: 10.17221/101/2014-AGRICECON
  40. Schwalbert R.A., Amado T., Corassa G., Pott L.P., Prasad P.V., Ciampitti I.A. (2020). Satellite-based soybean yield forecast: Integrating machine learning and weather data for improving crop yield prediction in southern Brazil. Agricultural and Forest Meteorology, 284, 107886. DOI: 10.1016/j.agrformet.2019.107886
  41. Spaulding A., Kanakasabai M., Hao J., Skees J. (2003). Can weather derivative contracts help mitigating agricul- tural risk? Microeconomic policy implications for Romania. International Conference on Policy Modeling, Istanbul, July 3-5.
  42. Statistical office of the Slovac Republic [online]. c2022 [cit. 2022-03-30].
  43. Stulec I., Petljak K., Bakovic T. (2016). Effectiveness of weather derivatives as a hedge against the weather risk in agriculture. Agricultural Economics, 62(8): 356-362. DOI: 10.17221/188/2015-AGRICECON
  44. Stulec I. (2017). Effectiveness of weather derivatives as a risk management tool in food retail: The case of Croatia. International Journal of Financial Studies, 5(2). DOI: 10.3390/ijfs5010002
  45. Swishchuk A., Cui K. (2013). Weather derivatives with applications to Canadian data. Journal of Mathematical Finance, 3(1). DOI: 10.4236/jmf.2013.31007
  46. Taušer J., Čajka R. (2014). Weather derivatives and hedging the weather risks. Agricultural Economics, 60(7): 309-313. DOI: 10.17221/11/2014-AGRICECON
  47. Timková M. (2018). Managing price risk in the corn market using option strategies. Acta Universitatis agriculturae et silviculturae Mendelianae Brunensis, 66(3): 767-779. DOI: 10.11118/actaun201866030767
  48. Torriani D.S., Calanca P., Beniston M., Führer J. (2008). Hedging with weather derivatives to cope with climate variability and change in grain maize production. Agricultural Finance Review, 68: 67-81. DOI: 10.1108/00214660880001219
  49. Trnka M., Olesen J.E., Kersebaum K.C., Rötter R.P., Brázdil R., Eitzinger J., Jansen S., Skjelvåg A.O., Peltonen-Sainio P., Hlavinka P., Balek J., Eckersten H., Gobin A., Vučetić V., Dalla Marta A., Orlandini S., Alexandrov V., Semerádová D., Šteěpánek P., Svobodová E., Rajdl K. (2016). Changing regional weather crop yield relationships across Europe between 1901 and 2012. Climate Research, 70(2-3): 195-214. DOI: 10.3354/cr01426
  50. Turvey C.G. (2001). Weather derivatives for specific event risks in agriculture. Applied Economic Perspectives and Policy, 23(2): 333-351. DOI: 10.2307/1349952
  51. Turvey C.G., Weersink A., Chiang S.H.C. (2006). Pricing Weather Insurance with a Random Strike Price: The Ontario Ice‐Wine Harvest. American Journal of Agricultural Economics, 88(3): 696-709. DOI: 10.1111/j.1467-8276.2006.00889.x
  52. Vedenov D.V., Barnett B.J. (2004). Efficiency of weather derivatives as primary crop insurance instruments. Journal of Agricultural and Resource Economics, 29(3): 387-403. DOI: 10.22004/ag.econ.30916
  53. Zapranis A.D., Alexandridis A.K. (2009). Weather derivatives pricing: Modeling the seasonal residual variance of an Ornstein-Uhlenbeck temperature process with neural networks. Neurocomputing, 73(1): 37-48. DOI: 10.1016/j.neucom.2009.01.018
  54. Zapranis A.D., Alexandridis A.K. (2011). Modeling and forecasting cumulative average temperature and heating degree day indices for weather derivative pricing. Neural Computing and Applications, 20(6): 787-801. DOI: 10.1007/s00521-010-0494-1
  55. Zara C. (2010). Weather derivatives in the wine industry. International Journal of Wine Business Research, 22: 222-237. DOI: 10.1108/17511061011075365
  56. Zhou R., Li J.S-H., Pai J. (2018). Evaluating effectiveness of rainfall index insurance. Agricultural Finance Review, 78(5): 611-625. DOI: 10.1108/AFR-11-2017- 0102
  57. Yang Ch.C., Shihong L.L., Wen M. (2011). Weather Risk Hedging in the European Markets and International Investment Diversification. The Geneva Risk and Insurance Review, Palgrave Macmillan; International Association for the Study of Insurance Economics, 36(1): 74-94. DOI: 10.1057/GRIR.2010.4