Risking-sharing Efficiency of Hedging Strategies
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Since agricultural production is significantly and directly influenced by weather, financial weather products based on temperature have been developed in recent decades. The crop producer can now hedge adverse temperature outcomes in either the exchange market or the over-the-corner (OTC) market. However, exchange-traded contracts invariably carry geographic basis risk because of differences in the market-quoted and local temperature outcomes. OTC option contracts, on the other hand, are at risk of possible default by the counterparty. Therefore, a portfolio combining OTC with exchange-traded contracts could potentially be used by crop producers to reduce overall income risk. In this paper, we examine the performances of these three alternative hedging strategies on the uncertainty of crop producer’s income. Using a case study for western Canada, we find that a portfolio that combines OTC and exchange-traded contracts provides a most effective means of reducing potential risks, compared with stand-alone OTC contracts or exchange-market contracts because of their higher default and geographic basis risks, respectively.