Weather Derivatives and Yield Index Insurance As Exotic Options

This paper develops methods to quantify weather derivatives and yield index insurance. These are exotic options that differ from financial options in several ways. The underlying random variable is not a price but a quantity such as millimeters of rainfall. Instead of option "pricing", a method must be developed for option "quantifying". Financial options are tradable. Weather derivatives and yield index insurance are not. Instead of being priced continuously, these are quantified once when the contract is written. As a result, they are less flexible. Financial options are linear. The probability distribution of an option is easily found from the probability distribution of the underlying price. Yield index insurance is a contract written on a non-linear function of random weather. Its probability distribution is unknown. Never-the-less, methods can be developed for quantifying weather derivatives and yield index insurance. Although there are many types of options in the literature, yield index insurance appears to be new. In the spirit of naming new options for exotic locations, yield index insurance could be called an "Australian" option, or Aussie option for short. Further research is needed to assess the likely demand for Aussie options by farmers and other rural businesses and the likely supply by financial institutions and insurers.