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Hedging weather risk for corn production in Northeastern China: The efficiency of weather-indexed insurance

Baojing Sun (Department of Economics, University of Victoria, Victoria, Canada)
Changhao Guo (Department of Economics, University of Victoria, Victoria, Canada)
G. Cornelis van Kooten (Department of Economics, University of Victoria, Victoria, Canada)

Agricultural Finance Review

ISSN: 0002-1466

Article publication date: 28 October 2014

458

Abstract

Purpose

The paper analyzes the hedging efficiency of weather-indexed insurance for corn production in Northeast of China. The purpose of this paper is to identify the potential weather variables that impact corn yields and to analyze the efficiency of weather-indexed insurance under varying thresholds for payouts (strike values).

Design/methodology/approach

Statistical relationships between climate variables and crop yields are used to construct weather-indexed insurance that enable a farmer to hedge against adverse precipitation outcomes. Mean root square loss is used to compare the efficiency of various weather products.

Findings

Based on efficiency comparisons, it turns out that in some, but not all circumstances, cumulative rainfall (CR) insurance can be used to hedge weather risk. When CR explains one-third or more of the variation in corn yields, a hedge can offset the revenue loss caused by the corresponding weather risk; but when it explains much less of the yield variation, it is inefficient for hedgers to buy weather insurance. If CR explains variation in crop yields, it is increasingly efficient to employ CR-indexed insurance as strike values decline for put options or increase for call options.

Practical implications

The paper provides a method for calculating the premium for an insurance product that provides a payout if CR in a growing season is too low.

Originality/value

This research is important because it illustrates the potential benefits of using weather insurance as an agricultural risk management strategy in China.

Keywords

Acknowledgements

The authors wish to thank the anonymous referees and, particularly, the editor, Dr Calum Turvey, for helpful comments and suggestions on an earlier draft of the paper. An earlier version of the paper was presented at the Second International Agricultural Risk, Finance and Insurance Conference held in Vancouver in June 2013. Research support from Canada's Social Sciences and Humanities Research Council is appreciated.

Citation

Sun, B., Guo, C. and Cornelis van Kooten, G. (2014), "Hedging weather risk for corn production in Northeastern China: The efficiency of weather-indexed insurance", Agricultural Finance Review, Vol. 74 No. 4, pp. 555-572. https://doi.org/10.1108/AFR-01-2014-0001

Publisher

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Emerald Group Publishing Limited

Copyright © 2014, Emerald Group Publishing Limited

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