Weather derivatives as a risk management tool for maize farmers in South Africa

Abstract

This study evaluates the value of rainfall options as a yield risk management tool in order to assess the viability of weather derivatives in the South African agricultural sector. Recent developments provide the potential of reducing agricultural risk factors through the introduction of derivatives based on weather variables. These instruments seem especially appealing because they are unaffected by asymmetric information and loss adjustment issues. Monthly rainfall averages combined with maize yield averages over a period of twenty years is used to find correlations between rainfall and yield. Through this discovery, it was possible to assess rainfall options as a risk management tool against yield risk for maize farmers in the water table soil area in the North-Western Free State. The concept, operation, and application of weather derivatives are mainly explained in this article. By weighing the advantages of rainfall options and recommending an option strategy as a yield risk management tool, the viability of using rainfall derivatives to control agricultural production risk in South Africa is assessed. Although weather derivatives have advantages over conventional insurances, the market for these instruments in South African agriculture is still limited. This is partially explained by the lack of clarity over whether, and to which extent weather derivatives can be used as a risk management tool in agriculture. To assess the risk-reducing benefit that can be obtained in maize production by adopting rainfall choices in South Africa, this study uses maize yield and weather data from North-Western Free State, which is the biggest maize producing province in South Africa (CEC, 2020). The contract design regulates the efficiency of hedging. . If pre-defined conditions associated with the underlying asset occur, one party (the investor) promises to make a financial commitment to another (the purchaser or contract owner). The writer receives an advance payment in exchange for this promise and the financial risk it entails. However, the farmer is still responsible for the geographical and basis risks. The study makes it possible to draw conclusions on the creation of weather derivatives. The issue raised here is pertinent to both farmers and potential sellers of weather derivatives. As capital markets, financial institutions, insurance companies, crop insurance companies, and hedge funds organize themselves to share and manage weather risks, the use of rainfall derivatives in South Africa is projected to rise in the future, thus the issue raised is pertinent to both farmers and potential weather derivative traders and underwriters.