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Modeling and Hedging Rain Risk

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  • Musshoff, Oliver
  • Odening, Martin
  • Xu, Wei

Abstract

In this article we price a precipitation option based on empirical weather data from Germany using different pricing methods, among them Burn Analysis, Index Value Simulation and Daily Simulation. For that purpose we develop a daily precipitation model. Moreover, a de-correlation analysis is proposed to assess the spatial basis risk that is inherent to rainfall derivatives. The models are applied to precipitation data in Brandenburg, Germany. Based on simplifying assumptions of the production function, we quantify and compare the risk exposure of grain producers with and without rainfall insurance. It turns out that a considerable risk remains with producers who are remotely located from the weather station. Another finding is that significant differences may occur between the pricing methods. We identify the strengths and weaknesses of the pricing methods and give some recommendations for their applications. Our results are relevant for producers as well as for potential sellers of weather derivatives.

Suggested Citation

  • Musshoff, Oliver & Odening, Martin & Xu, Wei, 2006. "Modeling and Hedging Rain Risk," 2006 Annual meeting, July 23-26, Long Beach, CA 21050, American Agricultural Economics Association (New Name 2008: Agricultural and Applied Economics Association).
    • Handle: RePEc:ags:aaea06:21050
    DOI: 10.22004/ag.econ.21050
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    File URL: https://ageconsearch.umn.edu/record/21050/files/sp06mu01.pdf
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    References listed on IDEAS

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    1. Sean D. Campbell & Francis X. Diebold, 2005. "Weather Forecasting for Weather Derivatives," Journal of the American Statistical Association, American Statistical Association, vol. 100, pages 6-16, March.
    2. Skees, Jerry & Gober, Stephanie & Varangis, Panos & Le, 2001. "Developing rainfall-based index insurance in Morocco," Policy Research Working Paper Series 2577, The World Bank.
    3. Richards, Timothy J. & Manfredo, Mark R. & Sanders, Dwight R., 2004. "Pricing Weather Derivatives," Working Papers 28536, Arizona State University, Morrison School of Agribusiness and Resource Management.
    4. Turvey, Calum G., 1999. "The Essentials Of Rainfall Derivatives And Insurance," Working Papers 34149, University of Guelph, Department of Food, Agricultural and Resource Economics.
    5. Peter Alaton & Boualem Djehiche & David Stillberger, 2002. "On modelling and pricing weather derivatives," Applied Mathematical Finance, Taylor & Francis Journals, vol. 9(1), pages 1-20.
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    Cited by:

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    Keywords

    Risk and Uncertainty;

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