Spatial Aggregation and Weather Risk Management

billion in 2004 to $22 billion through September 2005, with trading volume surpassing
630,000 contracts. While numerous authors have suggested the potential of weather
hedging in a reinsurance context on conceptual grounds (Glauber 2004; Skees and
Barnett 1999), earlier research suggests that the potential effectiveness of WDs at the
farm level may be limited (Vedenov and Barnett 2004). Evaluation at low levels of
aggregation, however, may not be relevant for re/insurers who are exposed to more
aggregated risks, but no clear explanation has been offered to clarify why one might
expect improved WD hedging performance at the re/insurance (i.e. aggregate) versus the
primary (i.e. farm) level.

This study attempts to bridge these gaps in the literature by proposing that WD
hedging may be more effective at higher levels of aggregation. Specifically, aggregating
production exposures across space may reduce idiosyncratic (i.e. localized or region
specific) risk in the aggregate portfolio. A greater proportion of the aggregate portfolio’s
total risk may be left in the form of systemic weather risk relative to idiosyncratic risk,
which may be effectively hedged using WDs. A conceptual model that supports this
notion is developed. The hypothesis is investigated at varying levels of aggregation using
Illinois corn during 1971-2002 at the CRD and state level.

The hedging analysis assumes minimization of semi-variance. The expected-
shortfall measure of tail-risk is also evaluated. These measures of downside risk are
more relevant to re/insurers, as they are typically more concerned with loss events. The
hedging analysis focuses on seasonal temperature derivatives in lieu of more complex
monthly precipitation and temperature derivatives used in previous studies for several
reasons. The interaction of temperature and precipitation during loss events, temperature

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