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A financial engineering approach to pricing agricultural insurances

Hirbod Assa (Institute for Financial and Actuarial Mathematics, University of Liverpool, Liverpool, UK)

Agricultural Finance Review

ISSN: 0002-1466

Article publication date: 5 May 2015

1919

Abstract

Purpose

The purpose of this paper is to introduce a continuous time version of the speculative storage model of Deaton and Laroque (1992) and to use for pricing derivatives, in particular insurances on agricultural prices.

Design/methodology/approach

The methodology of financial engineering is used in order to find the partial differential equations that the dynamics of derivative prices have to satisfy. Furthermore, by using the Monte-Carlo method (and Feynman-Kac theorem) the insurance prices is computed.

Findings

Results of this paper show that insurance prices (and derivative prices in general) are heavily influenced by market structure, in particular, the demand function specifications. Furthermore, through an empirical analysis, the performance of the continuous time speculative storage model is compared with the geometric Brownian motion model. It is shown that the speculative storage model outperforms the actual data.

Practical implications

Since the agricultural insurances in many countries are subsidised by government, the results of this paper can be used by policy makers to measure changes in agricultural insurance premiums in scenarios that market experiences changes in demand. In the same manner, insurance companies and investors can use the results of this paper to better price agricultural derivatives.

Originality/value

The issue of agricultural insurance pricing (in general derivative pricing) is of great concern to policy makers, investors and insurance companies. To the author’s knowledge, an approach which uses the methodology of financial engineering to compute the insurance prices (in general derivatives) is new within the literature.

Keywords

Acknowledgements

Several variations of this work were presented at different events, including the Mathematical Finance Days 2013 (HEC, Montreal), IARFIC 2013 (Vancouver), Frontier of Mathematics 2013 (Tehran), IARFIC 2014 (Zurich), IME 2014 (Shanghai), and FINACT-IRAN 2014 (Tehran). I would like to thank the people who have commented on this work and helped me to improve the quality of the paper through fruitful discussions. In particular, I would like to thank Calum Turvey, Nikolay Gospodinov and Bryan Campbell.

Citation

Assa, H. (2015), "A financial engineering approach to pricing agricultural insurances", Agricultural Finance Review, Vol. 75 No. 1, pp. 63-76. https://doi.org/10.1108/AFR-12-2014-0041

Publisher

:

Emerald Group Publishing Limited

Copyright © 2015, Emerald Group Publishing Limited

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