Spatial Aggregation and Weather Risk Management

Abstract

Previous studies identify limited potential efficacy of weather derivatives in hedging
agricultural exposures. In contrast to earlier studies which investigate the problem at
low levels of aggregation, we find using straight forward temperature contracts that
better weather hedging opportunities exist at higher levels of spatial aggregation.
Aggregating production exposures reduces idiosyncratic (i.e. localized or region
specific) risk, leaving a greater proportion of the total risk in the form of systemic
weather risk which can be effectively hedged using weather derivatives. The aggregation
effect suggests that the potential for weather derivatives in agriculture may be greater
than previously thought, particularly for aggregators of risk such as re/insurers.

Keywords: weather derivatives, spatial aggregation, corn, yield risk, crop insurance,
hedging

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