Use Of Weather Derivatives Research Articles

Potential use of weather derivatives in hedging aggregate viticulture yields: An analysis of the Niagara region of Canada

AbstractAlthough potentially useful for financially hedging systemic weather-related risks, weather contracts/derivatives (also referred to as parametric insurance) have not seen wide adoption in agriculture outside of applications in developing countries, frequently supported by governments and non-governmental organizations (NGOs). A significant impediment is the lack of financial firms willing to stand ready to sell weather derivatives to individual agricultural producers in the over-the-counter market who, due to the localized nature of weather, face idiosyncratic weather-related risks. In particular, the administrative and reinsurance costs of supplying relatively small contracts with specific terms to many different producers are often prohibitive. The current study considers the potential use of weather derivatives in hedging the aggregate yield/revenues of viticulture producers represented by an industry association located in the province of Ontario, Canada. We examine the sensitivity of aggregate industry yields to several relevant weather-related risks employing copula function analysis. We then consider the potential of a weather derivative in hedging the financial risk associated with cold winter temperatures, which pose the greatest risk to aggregate vinifera yields. The issue of attributing costs and payouts to individual association members remains unresolved, and several alternatives are suggested.

APPLICATION OF AIR DERIVATIVE FINANCIAL INSTRUMENTS IN LITHUANIAN ECONOMY

The paper explores the concept of weather derivatives: what it is, what its features are, and in what areas they can be applied. It has been established that there can be several types of weather derivative instruments – options and swaps. The use of weather derivatives has also been found to be very broad and attractive for tourism, construction, agriculture and heating companies. Companies operating in Lithuania do not use weather derivatives, although they do provide insurance against the risks associated with adverse weather conditions. The paper is conducting a study to determine which heating companies should apply weather derivatives to improve their performance. The study is conducted using multi-criteria assessment methods – SAW and TOPSIS. The multi-criteria assessment showed that AB Šiaulių energija and UAB Varėnos šiluma could use the opportunity to apply weather derivatives in their activities.

Managing construction risk with weather derivatives

Among construction industry participants, weather has been perceived to be one of the most critical factors impacting project cash-flows. The overall impact of weather on the contractor’s project objectives is non-trivial due to construction industry incentive structures and contract specifics. This paper presents a framework that leverages stylized facts from the construction industry to motivate the use of weather derivatives in managing the non-trivial weather impacts. The proposed framework is demonstrated using data provided by a large construction contractor. We show that weather derivative portfolios used for hedging purposes by the contractor can address the contractor’s aversion for losses as well as the complicated relationship between weather and construction. Furthermore, weather derivative hedging reduces the contractor’s incentive to partake in risk chasing behavior in the face of weather delays and reduces the likelihood of the contractor exploiting other claims channels within the project contract.

English

The purpose of this paper is to test a temperature-based pricing model of Alaton (2002) in main rice-growing cities of Vietnam. The results of the test are then used for loss hedging analysis and policy implications for Vietnamese farmers, investors and related parties. Data are collected from General Statistics Office (GSO) of Vietnam, 2017 and Vietnam Meteorological and Hydrological Administration, with a reference to acuweather.com, on which the Alaton model is run. We suggest that temperature-based options are great tools for Vietnamese farmers to hedge unfavorable weather risks, and for investors to earn speculative profits. The great geographic diversity among Vietnam cities shows that there is a great potential to expand option contracts nationwide. By far, we acknowledge that findings are constrained by the limited temperature data in Vietnam, and the lack of comparable market prices. Furthermore, the pricing model itself assumes normal distribution, which might not fully capture the evolution of daily and seasonal temperature. Weather derivatives, especially the covered temperature-based options, are potential insurance for farmers and agricultural manufacturers besides existing price subsidiaries. From a policy perspective, the establishment of an active trading market can support the expanded use of weather derivatives within and outside the agriculture sector. Key words: derivatives, mean-reversion process, agricultural finance.

Weather Derivatives in Russia: Farmers’ Insurance against Temperature Fluctuations

This project proposes the use of weather derivatives, a type of financial instrument with a payout based on weather conditions, as a method for Russian farmers to hedge against daily temperature fluctuations. We created a weather derivative simulation tool in Microsoft Excel that calculates the effect of temperature on crop yield and then analyzes how the return of weather derivatives can potentially compensate for crop loss. Based on this tool, we developed a series of recommendations to help implement this system of protection with real users.

Public Sector Risk Financing: Exploring the Potential Use of Weather Derivatives by Fire and Rescue Services

The floods of 2007, experienced across much of England, resulted in local authority organisations, including Fire and Rescue Services, mounting large-scale responses and incurring additional and unexpected expenditure. Although central government activated funding schemes, some local authorities fell below the thresholds set and had to absorb the additional costs. This raised a question of what alternative methods were available to allow these local authority organisations to finance such unexpected costs. Weather derivatives are widely used in certain sectors to manage the financial risk that arises from undesirable weather conditions and the objective of this research is to explore the reactions of an FRS towards the use of these financial instruments in managing additional costs, such as those arising from the 2007 floods. Our findings suggest that a combination of risk-aversion, lack of specific financial knowledge and comfort with the status quo seem set to stifle development of weather derivatives as an innovation in public sector risk financing. However, this exploratory study suggests that the method has some merit and is at least worthy of further examination.

Hedging effectiveness of weather derivatives in arable farming – is there a need for mixed indices?

PurposeThe use of weather derivatives is impaired with a basis risk which diminishes the hedging effectiveness and hinders the distribution of these risk management instruments in the agricultural sector. A frequently suggested approach to reduce the basis risk is the use of mixed indices composed of several weather variables. The purpose of this paper is to compare the hedging effectiveness of a simple temperature‐based and a simple precipitation‐based weather derivative with that of a derivative based on a mixed index of two weather variables.Design/methodology/approachThe basis of this comparison are empirical yield time series of the winter wheat production of 32 farms located in central Germany, as well as daily temperature and precipitation data collected by selected weather stations over several years. Insurance is structured as an option on an accumulated weather index and priced by index‐value simulation. In addition, the bootstrapping method is used to improve statistical reliability. The hedging effectiveness is measured non‐parametrically regarding the relative reduction of the standard deviation of winter wheat revenues caused by using weather derivatives.FindingsThe results reveal that mixed index‐based weather derivatives have a significantly higher potential to reduce the risk of winter wheat revenues than simple index‐based weather derivatives. However, using mixed index‐based weather derivatives does not lead to a significantly higher hedging effectiveness than the simultaneous use of several simple index‐based weather derivatives. Moreover, simple index‐based weather derivatives may more easily raise the interest of other industries which could serve as potential trading partners for the agricultural sector.Research limitations/implicationsThe authors analyzed the hedging effectiveness of weather derivatives based on simple and mixed indices with regard to the production of winter wheat in Central Germany. To confirm that the present results are generalizable, further research is required for other types of production apart from winter wheat cultivation and with respect to other regions besides Germany.Practical implicationsThe focus and results of the present study are very relevant for farmers as well as for potential providers of weather derivatives. The results reconfirm that weather derivative providers should better offer different weather derivatives based on a simple index than complex derivatives that are based on a mixed index.Originality/valueTo the best of the authors' knowledge, this paper is the first that provides a comparative impact analysis of simple and mixed index‐based weather derivatives conducted for real individual farms with regard to their hedging effectiveness.

Managing Risk of Ski Resorts with Snow Options

The main problem for the tourism businesses which operate in ski resorts is that their revenue are strictly connected to the cumulative snowfall level. The uncertainty about the snowfall due the climate changing has made this type of business highly risky, for this reason few or no investments are made every year to improve the resorts, the slopes or the lifts; continuing in this way, the resort in few years will face to a loss in competitiveness, thus less tourists, less revenue and less business. The present work purposes to show a possible hedging strategy against the financial problems due to the scarcity of snow: the weather derivatives. Due to the fact that in Italy there are many ski resorts situated at an altitude from 1300m to 2000m, we focus our analysis on Andalo, in Italian Alps and we obtain the estimated prices of a put snow option by applying three different methods proposed in literature. We suggest, finally, the ideal prices for Paganella lift operator in Andalo, showing how the use of weather derivatives may be very helpful in the risk management for ski resort related to snow scarcity events.

Weather Value at Risk: On the Measurement of Noncatastrophic Weather Risk

AbstractAn evaluation of weather risk entails two important objectives: indicating the economic impact of weather variability and climate change, and evaluating the use of weather derivatives in weather risk reduction and climate change adaptation strategy. This paper illustrates a straightforward approach for measuring weather risk, which captures both the exposure and the sensitivity of business and economic indicators to weather variability. Using the example of the accommodation industry in Kitzbuehel (Austria), it is demonstrated that the risk measure Weather-VaR can be used to serve both ends. It is found that compared to a normal climatological season, adverse snow conditions (at the level of a 1 in 20-yr event) result in a substantial financial loss of approximately 4 million euros. However, results show that quantification of weather risk is substantially affected by the choice of the weather variable or index, the time period under consideration, the model specification for estimating the sensitivity parameter, and whether time trends are considered when estimating the probability of unfavorable weather conditions.

Weather Derivatives: Usage Possibilities for the Lithuanian Economy

The impact of weather on many commercial and recreational activities is significant and varies both geographically and seasonally. Many industries, including agriculture, energy, utility, construction, tourism and other businesses, are either favourably or adversely affected by “bad” weather. For this reason, financial markets have devised a relatively new class of instruments, the so-called “weather derivatives”, the first of which were launched in 1996 in the United States. There is a number of factors behind the growth in the weather derivatives market. One of these is the deregulation of energy markets. Another one is that capital and insurance markets have come closer to each other. A weather derivative is the new­est product of the financial derivatives market. It al­lows a market participant to minimise a risk from daily weather fluctuations, while insurance companies sell insurance against catastrophic events.
 The main aim of this article is to explore possi­bilities to use weather derivatives for the Lithuanian economy. To reach the aim, the following goals were set: to describe products of weather derivatives and their features and to present the possibilities to use these derivatives in the Lithuanian economy on the basis of an example of temperature derivatives. A hypothesis is made that Lithuanian companies could discover new possibilities for business management through the use of weather derivatives.
 The methods used in the paper are as follows: comparative analysis, indexes, regression and correla­tion analysis.

Climate Change and the Potential Use of Weather Derivatives to Hedge Vineyard Harvest Rainfall Risk in the Niagara Region

The widespread recognition of current and impending climate change has led to the examination of possible impacts and potential adaptation strategies to deal with the prediction of increased variability of weather. Viticulture in particular faces a myriad of weather-related risks that could increase significantly with climate change. In addition to changes in agricultural practices, the use of financial solutions must also be sought in order to deal with the impending economic risks. Weather derivative contracts are a growing market that provide for the hedging of many of the financial risks due to weather. Although their use is widespread and increasing, their adoption by the agricultural sector, including viticulture, has been relatively slow. Using the Niagara region of Canada, we provide an example of how a weather contract can be designed to hedge the financial risk of a critical weather-risk factor common in viticulture, that of excessive rainfall during the harvest season. The variability of rainfall in the Northern Hemisphere has been predicted to increase with climate change and if weather-related risks intensify, weather contracts could prove to be useful tools for the viticulture industry.

The Use of Weather Derivatives by Small- and Medium-Sized Enterprises: Reasons and Obstacles

Weather events have a strong influence on the operating figures of small- and medium-sized enterprises (SMEs). The emergence of weather derivatives offers opportunities to manage these weather-related risks. General pricing and valuation issues of weather derivatives have already been widely discussed in the literature, but, so far, no research has been undertaken to examine the reasons and obstacles regarding the usage of weather derivatives within a SME context. The present paper fills this research gap. It introduces the fundamental characteristics of weather derivatives and reviews the theoretical hedging rationales of SMEs. Above all, this paper presents and discusses obstacles that may impede the application of weather derivatives by SMEs. According to results of a survey conducted among 215 Austrian SMEs, the primary obstacles are the lack of expertise and awareness regarding weather risk management.

Determinants of weather derivatives usage in the Austrian winter tourism industry

This study investigates the motivations, concerns and obstacles regarding the use of weather derivatives in the winter tourism industry. The findings from the interviews with 61 ski lift operators in Austria indicate that while the majority of operators are aware of weather risks and report substantial weather exposure, using weather derivatives as a means of offsetting potential loss is rarely considered. This is primarily due to a lack of awareness and knowledge, but on becoming aware of the availability of such instruments ski lift operators express interest in their possible use. The task is thus to increase awareness, knowledge and support for the ski lift operators with reference to the use of weather derivatives.

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

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.

A study of basis risk in the use of weather derivatives for hedging of agricultural yield

Weather derivatives are a newer form of hedging the weather-related agricultural yield risk. The paper discusses the issue of geographic basis risk, which is likely to be an important factor when weather derivative trading is introduced in India. With the large number of villages and the large geographic spread, an understanding of the implications of basis risk would help, not only in the acceptability of weather derivatives as viable hedging instruments, but also in relevant policy matters. This would be so especially with respect to the number and kind of weather recording stations which would be required. The paper brings out a study of past data from two weather stations in New Delhi, located just a few kilometers apart, on rainfall correlations and uses these to indicate risks involved in using proxy weather stations.

Design and use of weather derivatives for farmers: the case of hedging rain risk by soyabean growers in Jhalawar district in India

In the absence of a market for weather derivatives in India, the paper discusses a hypothetical market, and how a contract could be structured when weather derivative trading is introduced. A survey was conducted in six villages in two districts in the state of Rajasthan in order to assess the inclination of small farmers to use weather derivatives to hedge yield risk and to determine their willingness to pay. The findings of the amount that the farmers would be willing to pay are used in this paper. The need of the hour is to have a simple method for determining the price of an option on a rainfall index, so that a possible contract is feasible both for the seller as well as for the buyer. This is brought out in the paper using the case of soyabean growers in Jhalawar district.

Hedging Rainfall Risk by Farmers Growing Soyabean in Jhalawar District

Rainfall risk to the yield of a crop can be hedged, to an extent, by the use of weather derivatives. The paper considers a theoretical model which maximises the expected utility of a farmer growing a crop, with respect to planned production. An option to hedge the weather risk to yield, through purchase of weather derivatives, is introduced. The case of farmers growing soyabean in Jhalawar district of Rajasthan in central India is taken as an example in order to determine the theoretical willingness to pay to hedge volumetric risk to yield.

Managing Weather Risk with the Use of Derivatives

The present study deals with climate risk management by the use of weather derivatives and the issue of bonds. The study will focus on the Greek agricultural economy, which is affected by weather conditions. In more detail, this is a presentation of the Greek agricultural economy and of the practices followed for managing the risks faced by farmers. Also included are the reasons why current practices can no longer be applied and thus this present study proposes a solution for climate risk management. Finally, the project presents the parties that take a direct interest in the management of the risk arising from natural disasters and a detailed description of weather derivatives. This project is co-funded by the European Union - European Social Fund & National Resources - EPEAEK.

Using weather derivatives to hedge precipitation exposure

PurposeThe purpose of this study is to demonstrate the use of weather derivatives to hedge firm exposure to previously unmanageable risk events caused by natural phenomenon such as excessive rainfall.Design/methodology/approach – The paper adopts a case study approach to meet the objectives above, focusing on golf courses in the Midwest USA, which provide perfect examples of businesses with seasonal cash flows.Findings – It is shown that a firm can reduce its revenue volatility by up to 80 per cent. Weather derivatives are important additions to firm portfolios of risk management tools. Purchasing weather derivatives will improve the owner's ability to forecast revenues and assure expenditure coverage, both important goals for a small business owner.Practical implications – Many firms find the uneven revenue streams associated with their industry to be difficult to manage. One of the primary risks faced by firms is exposure to weather phenomena. With the introduction of weather derivatives, firms can now hedge their exposure to climatologic events. The application for weather derivatives is quite limitless. Weather derivatives are a relatively new product, and most firms are either unaware of their existence or believe them to be complicated. It is an industry that may experience explosive growth in the coming years.Originality/value – This paper demonstrates the use of derivatives to hedge exposure to climatic events.

Canadian Ice Wine Production: A Case for the Use of Weather Derivatives

AbstractWeather derivatives are a relatively new form of financial security that can provide firms with the ability to hedge against the impact of weather related risks to their activities. Participants in the energy industry have employed standardized weather contracts trading on organized exchanges since 1999 and the interest in non-standardized contracts for specialized weather related risks is growing at an increasing rate. The purpose of this paper is to examine the potential use of weather derivatives to hedge against temperature related risks in Canadian ice wine production. Specifically we examine historical data for the Niagara region of the province of Ontario, Canada, the largest icewine producing region of the world, to determine an appropriate underlying variable for the design of an option contact that could be employed by icewine producers. Employing monte carlo simulation we derive a range of benchmark option values based upon varying assumptions regarding the stochastic process for an underlying temperature variable. The results show that such option contracts can provide valuable hedging opportunities for producers, given the historical seasonal temperature variations in the region. (JEL Classification: G13, G32, Q14, Q51, Q54)