Spatial Aggregation and Weather Risk Management

autocorrelations, and high computation costs limit the potential benefits of more complex
WDs. Also, transaction costs associated with negotiating over-the-counter (OTC)
precipitation derivatives are likely high, and their potential for liquidity low, relative to
temperature derivatives. Further, the markets for the temperature derivatives traded at the
CME are currently the most developed WD markets. The WDs employed here, which
are highly consistent with the CME contracts in structure, thus appear to present a
promising avenue for current research.

Weather Risk in Crop Insurance Markets

In contrast to earlier studies on failures in crop insurance markets, Miranda and Glauber
(1997; hereafter MG) propose that systemic weather risk poses a serious obstacle to the
emergence of independent private crop insurance markets because widespread adverse
weather induces significant correlations among individual farm-level yields. MG
estimate that US crop insurer portfolios are between twenty to fifty times riskier than they
otherwise would be if yields were independent. Thus, the lack of independence among
individual yields causes crop insurers to bear substantially higher risk per unit of
premium than other property liability and business insurers.

In order to induce insurers to underwrite crop insurance, insurers in the United
States are provided reinsurance protection by the government under the Standard
Reinsurance Agreement (SRA). The SRA imposes large administrative costs on the
public. Further, the extent to which the SRA effectively transfers systemic risks from the
insurer to the government is not known. Ineffective transfer of systemic risk under the
SRA may impose additional costs on the government if insurers do not have the

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