The risks associated with farming activities are likely to increase in the future. It, therefore, appears worthwhile to analyse new risk management instruments. This paper investigates weather derivatives for which a market has already emerged in the USA. Contrary to traditional financial derivatives, their payoff is determined by future weather events, such as temperature or precipitation. Thus, they hedge risks which result from climate. Since they address production risks they are complementary to instruments that hedge price risks, such as future markets.
The objective of the paper is to evaluate the economic impacts of weather derivatives and to assess their potential as farm level instruments of risk management. After outlining the main characteristics and the functioning of weather derivatives and their emergence, emphasis is placed on model calculations to quantify farm level impacts. The potato farm is used as a case study. Empirical data on yields and weather variables are taken from an experiment station of the Chamber of Agriculture at Hanover, Germany. After studying the relationship between yields and weather variables, the findings are used to design an option based on a precipitation index. Stochastic simulation is then used to assess the effects on the probability distribution of revenues.
The results show that weather derivatives can be useful instruments of risk management in agriculture. Since there is still a lack of knowledge with respect to some of their economic impacts, further research is needed. This refers to the choice of suitable commodities and weather indexes, the contractual design and methodological aspects of pricing and of integrating weather derivatives into the risk management of farms. Last but not least, the question has to be answered, as to which partners would be willing to accept the risk that farmers intend to reduce by means of weather derivatives.
