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Weather Derivatives In The Presence Of Index And Geographical Basis Risk: Hedging Dairy Profit Risk

Author

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  • Chen, Gang
  • Roberts, Matthew C.

Abstract

Weather conditions pose unique risks to dairy producers. Weather derivatives represent a potentially promising approach to augment dairy producers' risk management against adverse weather events. This study examines the effect of basis risk in weather derivatives, and whether the existence of basis risk mitigates the usefulness of weather derivatives for dairy risk management. Assuming a representative dairy producer has access to both weather derivatives and traditional heat abatement equipment, a closed-form solution for his/her optimal portfolio choice problem in the presence of basis risk is derived within a mean-variance utility framework. First-, second-, and third- degree stochastic dominance criteria are used to test the risk management effectiveness with less restrictive assumptions. Also proportional transaction costs are imposed on weather derivative prices calculated on the basis of actuarial fairness to allow the desirability of these contracts to their issuers.

Suggested Citation

  • Chen, Gang & Roberts, Matthew C., 2004. "Weather Derivatives In The Presence Of Index And Geographical Basis Risk: Hedging Dairy Profit Risk," 2004 Conference, April 19-20, 2004, St. Louis, Missouri 19030, NCR-134 Conference on Applied Commodity Price Analysis, Forecasting, and Market Risk Management.
    • Handle: RePEc:ags:ncrfou:19030
    DOI: 10.22004/ag.econ.19030
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    File URL: https://ageconsearch.umn.edu/record/19030/files/cp04ch01.pdf
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    Cited by:

    1. Marcos Gallacher & Daniel Lema & Alejandro Galetto & Laura Gastaldi, 2015. "Climate variability and agricultural production in Argentina: the role of risk-transfer mechanisms," CEMA Working Papers: Serie Documentos de Trabajo. 583, Universidad del CEMA.
    2. Marcos Gallacher & Daniel Lema & Laura Gastaldi & Alejandro Galetto, 2016. "Climate variability and agricultural production in argentina: the role of risk-transfer mechanisms," Ensayos de Política Económica, Departamento de Investigación Francisco Valsecchi, Facultad de Ciencias Económicas, Pontificia Universidad Católica Argentina., vol. 2(4), pages 11-38, Octubre.
    3. M. Ritter & O. Mußhoff & M. Odening, 2014. "Minimizing Geographical Basis Risk of Weather Derivatives Using A Multi-Site Rainfall Model," Computational Economics, Springer;Society for Computational Economics, vol. 44(1), pages 67-86, June.
    4. Å tulec, Ivana & Petljak, Kristina & Naletina, Dora, 2019. "Weather impact on retail sales: How can weather derivatives help with adverse weather deviations?," Journal of Retailing and Consumer Services, Elsevier, vol. 49(C), pages 1-10.
    5. Xiaohui Deng & Barry J. Barnett & Dmitry V. Vedenov & Joe W. West, 2007. "Hedging dairy production losses using weather‐based index insurance," Agricultural Economics, International Association of Agricultural Economists, vol. 36(2), pages 271-280, March.

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    Keywords

    Marketing; Risk and Uncertainty;

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