Practical Approaches to Designing Weather Derivatives Under Yield Data Limitations

Abstract

This paper implements several contract design strategies to evaluate the effectiveness of simple semi-naive approach to index construction that can be implemented in situations where only short and/or aggregate data series are available. In order to mitigate the aggregate nature of the available yield data, we attempt to look at areas sharing the same growing conditions rather than simply located within the same administrative boundaries. In order to avoid the need for data-demanding analysis, we use agronomic requirements to specify parameters of insurance contracts, called agronomic contracts in this paper. The risk reduction of thus constructed weather index contracts, are evaluated and compared with the performance of the “optimal” contracts suggested in the literature. While the agronomic contracts do not achieve the same degree of risk reduction as the “optimal” contracts, they do provide meaningful risk protection and typically at lower premiums. As expected, the agronomic contracts perform better in homogeneous production areas.