Spatial Aggregation and Weather Risk Management

aggregators of risk such as re/insurers. Further, the use of simple temperature derivatives
may provide risk management benefits which are reasonably effective and also more
consistent than those provided by complex multivariate WDs. Given the problems that
systemic weather risk has caused in crop insurance markets and also considering that
crop insurance is now widespread with more than 75% of corn and soybeans planted in
2003 insured (Coble et al 2004), our findings may be of interest to market-makers,
re/insurers, and policy makers. In addition, the aggregation effect outlined here may also
be applicable to other domains such as natural gas consumption.

Several qualifications are in order. First, this study only considers WDs written
on local and relatively remote weather stations. It is likely that the transaction costs
associated with negotiating WDs in the OTC market on remote weather stations would
entail high transaction costs and render these contracts infeasible. However, WDs written
on ACDD indexes for major international cities trade on the CME. Given the great
potential liquidity for these CME contracts and the high degree of spatial correlation in
temperatures, an assessment of geographical basis risk for larger areas using CME
contracts may be an interesting area of future research.

This analysis does not consider actual re/insurer portfolios, but rather only
establishes the basis for the spatial aggregation effect in yield hedging applications
involving WDs. It is likely, however, that yield risk is a reasonable proxy for re/insurer
risk. For instance, Hayes, Lence and Mason (2004) find that the RMA’s reinsurance risk
stems mostly from yield, or quantity, risk. Still, future research of WD hedging with
special attention to specification of the re/insurer portfolio is needed. This may also
include addressing price risk, which is not considered here. Given the growing

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