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A spatial Bayesian approach to weather derivatives

Nicholas D. Paulson (University of Illinois, Urbana, Illinois, USA)
Chad E. Hart (Iowa State University, Ames, Iowa, USA)
Dermot J. Hayes (Iowa State University, Ames, Iowa, USA)

Agricultural Finance Review

ISSN: 0002-1466

Article publication date: 11 May 2010

542

Abstract

Purpose

While the demand for weather‐based agricultural insurance in developed regions is limited, there exists significant potential for the use of weather indexes in developing areas. The purpose of this paper is to address the issue of historical data availability in designing actuarially sound weather‐based instruments.

Design/methodology/approach

A Bayesian rainfall model utilizing spatial kriging and Markov chain Monte Carlo techniques is proposed to estimate rainfall histories from observed historical data. An example drought insurance policy is presented where the fair rates are calculated using Monte Carlo methods and a historical analysis is carried out to assess potential policy performance.

Findings

The applicability of the estimation method is validated using a rich data set from Iowa. Results from the historical analysis indicate that the systemic nature of weather risk can vary greatly over time, even in the relatively homogenous region of Iowa.

Originality/value

The paper shows that while the kriging method may be more complex than competing models, it also provides a richer set of results. Furthermore, while the application is specific to forage production in Iowa, the rainfall model could be generalized to other regions by incorporating additional climatic factors.

Keywords

Citation

Paulson, N.D., Hart, C.E. and Hayes, D.J. (2010), "A spatial Bayesian approach to weather derivatives", Agricultural Finance Review, Vol. 70 No. 1, pp. 79-96. https://doi.org/10.1108/00021461011042657

Publisher

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Emerald Group Publishing Limited

Copyright © 2010, Emerald Group Publishing Limited

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