ISSUES OF GEOGRAPHICAL BASIS RISK IN WEATHER DERIVATIVES FOR AUSTRALIAN WHEAT FARMERS

Weather derivatives are designed to hedge the volumetric risk associated with unfavourable weather. They have the ability to hedge weather related volume or yield risk for the agricultural sector, although there are still many hurdles to their widespread implementation in Australian agriculture. This paper focuses on one of these hurdles, the problem of geographical basis risk resulting from the distance between the subject property and the site at which the weather measurement takes place. Geographical basis risk changes the frequency and magnitude of payouts, which can pose a substantial deterrent to farmers. This study uses data from two farms in NSW to determine differences in payouts when calculated from varying data measurement sites. It is found that at smaller geographical distances the magnitude of payouts is only slightly affected, while as the distance between farm and weather measurement increases, both frequency and magnitude of payouts are affected, thus lowering the potential demand for weather derivatives by farmers.