Hedging Yield with Weather Derivatives: A Role for Options

While there are few risk management alternatives available to specialty crop growers, weather derivatives provide an important advancement. As with the use of any derivatives contract, the behavior of the basis will ultimately determine the net-hedged outcome. However, when using weather derivatives to hedge yield risks for specialty crops, growers face a unique form of basis risk because weather (temperature) and yield are nonlinearly related. Using the forecast encompassing principle, this research shows that the nonlinear relationship between yield and weather creates a role for options in an optimal hedging program. The results suggest that weather derivative instruments with nonlinear payoffs, such as options, be used in combination with linear payoff instruments, such as swaps or futures, to minimize basis risk associated with the nonlinear relationship between yields and weather.