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

Purpose - The 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/approach - The 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. Findings - The 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/implications - The 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 implications - The 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/value - To 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.