Feasibility of Weather Derivatives for Agriculture Risk Reduction in Sri Lanka

Abstract

Most of the economic activities; especially manufacturing industries and agriculture have high dependency on weather. Virtually every sector of the economy is directly or in-directly subject to the influence of the adverse weather conditions and in some situations consequences are catastrophic. Extreme temperature and precipitation are the most common and persuading variables which unfavourably affect crop yield. Hedging the yield risk in agriculture is a serious business due to the spontaneous nature of weather events. One emerging concept is the development of index based financial instruments that allow producers to securitize their yield and circumvent the loss after a disastrous weather event. This study is focused to price and determine the performance of an index based weather derivative for Sri Lanka. Paddy productivity was modelled by a time series regression model. Probability density function of the index was estimated. Expected value of the index distribution was selected as the strike price to assure at least some indemnity if predicted yields dropped below the long term average. Integral of the pay-off function over the probability density function of the index is the actuarially-fair price. Maximum indemnity is calculated by minimizing the aggregate measure of down-side loss. Optimum number of unit contracts is subject to the minimum revenue risk. The performance of the contract is proved by Value-at-Risk. The derivative provides risk-protection against yield shortfalls. A dynamic and aggregate portfolio will increase the derivative writers’ profit.

Keywords: Regression, Weather derivatives, Actuarially-fair-price, Value-at-Risk

JEL Classification: C51, G13, Q19