Weather derivates - Applicability in the Agribusiness

<p>It is well known that weather is an important production factor in agriculture. Unfortunately, this production factor can hardly be controlled. In fact, weather risks are a major source of uncertainty in agriculture and it seems that fluctuations of temperature and precipitation even increased in the last decade due to global climate changes. Drought or excess rain is responsible for bad harvests all over the world. Perhaps the most obvious impact of weather risk is on crop yields, but its relevance is not limited to crop production. The performance of livestock farms, the turnover of processors, the use of chemicals and fertilizers and the demand for many food products also depend on the weather. Hence, large parts of the agribusiness are affected by weather risks. In the EU the problem of production risk is even more relevant since price volatility is expected to increase due to recent policy reforms.</p>
<p>Traditionally, producers try to compensate the negative economic consequences of bad weather events by buying insurance. However, in the mid nineties a new class of instruments has emerged, namely weather derivatives. Generally spoken, weather derivatives and index based weather insurance are financial instruments that allow to trade weather related risks. These instruments include futures, options, and swaps.</p>
<p>While the first transactions were based on bilateral contracts, standardized products are nowadays also traded on exchanges, e.g. the Chicago Mercantile Exchange (CME). Until now most transactions take place in the energy sector, but some promising applications also exist in agriculture. For example, the World Bank has launched weather-related insurance projects in Morocco and Nicaragua. In the Canadian provinces Alberta and Ontario weather risk instruments have also been used to hedge production risk. The question arises if and to what extent weather derivatives can play a role as useful risk management tools in the agribusiness. This issue is not only important for farm managers but also for policy makers, since income stabilization in agriculture is frequently considered as a governmental task.</p>