Efficiency of weather derivatives for Chinese agriculture industry

Abstract

Purpose

The purpose of this paper is to analyze the efficiency of temperature-based weather derivatives (WD) in reducing risk exposure for Chinese agriculture industry. Therefore, a put option with cumulated growing degree days as its underlying index is assumed to be bought by farmers as a risk management instrument to prevent income fluctuations from adverse temperature conditions.

Design/methodology/approach

The objective of this paper is to analyze the efficiency of temperature-based WD in reducing risk exposure for Chinese agriculture industry. Therefore, a put option with cumulated growing degree days as its underlying index is assumed to be bought by farmers as a risk management instrument to prevent income fluctuations from adverse temperature conditions.

Findings

The results of the efficiency tests show that temperature-based put options are efficient in offsetting yield shortfalls for rice and wheat in China. The weather-yield models have a high prediction power in explaining yield variation by temperature.

Research limitations/implications

The de-trending procedure for the weather-yield model should be improved to distinguish better between technology progress, human activities and influence of weather. Further, more advanced models could be used for the pricing.

Practical implications

The findings of the paper support the launch of WD as an efficient risk management tool for agriculture in China. Compared with traditional damage-based insurance, WD are more flexible, have lower transactions costs and avoid moral hazard or adverse selection.

Originality/value

The efficiency problem of WD has not been analyzed sufficiently worldwide and especially not for developing countries like China where a large proportion of the population works as farmers. This paper supports to fill this gap.

Citation

Ender, M. and Zhang, R. (2015), "Efficiency of weather derivatives for Chinese agriculture industry", China Agricultural Economic Review, Vol. 7 No. 1, pp. 102-121. https://doi.org/10.1108/CAER-06-2013-0089