Spatial Aggregation and Weather Risk Management

Previous studies identify limited potential efficacy of weather derivatives in hedging agricultural exposures. In contrast to earlier studies which investigate the problem at low levels of aggregation, we find using straight forward temperature contracts that better weather hedging opportunities exist at higher levels of spatial aggregation. Aggregating production exposures reduces idiosyncratic (i.e. localized or region specific) risk, leaving a greater proportion of the total risk in the form of systemic weather risk which can be effectively hedged using weather derivatives. The aggregation effect suggests that the potential for weather derivatives in agriculture may be greater than previously thought, particularly for aggregators of risk such as re/insurers.