The analysis of the hedge effectiveness of weather derivatives

Weather risk affects the economies worldwide in macroeconomic way and but also all economic sectors are to some extent weather sensitive. As a subpart of weather risk, the impacts of the catastrophic weather risks have been long managed by the insurance and reassurance companies. However the managing of the non- catastrophic weather risks gains in impotance as the climate change affects becomes more pronounced in all economic sectors. Weather derivatives are financial instruments that provide flexible solutions to companies to insure themselves against the losses they can incur because of non- catastrophic weather risks. While many studies touch on the problem of pricing of weather derivatives, few studies have looked at the hedge efficiency of these products. Therefore, the main purpose of this study is to design a weather derivative contract and analyze the hedging efficiency in the agriculture sector at Turkey. Firstly, using historical data, the relationship between corn yield (kg/daa) and cumulative growing degree days which is generally used in agriculture sector is examined. Then, the structure of this weather derivative is explored. Thirdly, option premium is calculated based on Burn Analysis method. Lastly, hedge effectiveness of the weather derivative is analyzed by using the variance method. Results show that using weather derivatives reduces the farmers' income volatility between 14% and around 34%. Also, findings show that as the correlation between corn yield and underlying asset of weather derivatives increases, the income volatility of farmers tend to show higher decreases. Keywords: Weather risk, Weather Derivatives, Hedging, Hedge Effectiveness, Variance Method