Hedging crop yield with exchange-traded weather derivatives

The application of weather derivatives in hedging crop yield risk is gaining more interest. However, the further development of weather derivatives – particularly exchange-traded – in the agricultural sector has been impeded by concerns over their hedging performance. The purpose of this paper is to develop a new framework to derive the optimal hedging strategy and evaluate hedging effectiveness.

This framework incorporates a stochastic temperature model, a crop yield model, a risk-neutral pricing method and a profit optimization procedure. Based on a large number of simulated scenarios, the authors study crop yield hedge for a future year. The authors allow the hedger to choose from different types of exchange-traded weather derivatives, and examine the impact of various factors on the optimal hedging strategy.

The analysis shows that hedging objective, pricing method and geographical location of the hedged exposure all play important roles in choosing the best hedging strategy and assessing hedging effectiveness.

This framework is forward-looking, because it focusses on the crop yield hedge for a future year rather than on the historical hedging effectiveness often studied in literature. It utilizes the most up-to-date information related to temperature and crop yield, and hence produces a hedging strategy which is more relevant to the year under consideration.