Weather derivatives: Concept and application for their use in South Africa

Publication´s abstract

The use of rainfall derivatives in South Africa is likely to increase in future as capital markets, financial institutions, insurance companies, crop insurance companies and hedge funds collectively organise themselves to share and distribute weather risks. The paper first describes the concept, functioning and application of weather derivatives. It then examines the feasibility of rainfall derivatives to manage agricultural production risk in South Africa by evaluating the merits of rainfall options, and suggesting an option strategy, as a yield risk-management tool.

Conclusions:

• For many weather derivatives traded in the energy sector, for example derivatives on heating degree days (HDD), the relationship between temperature and demand for heating is simple and direct: the lower the HDD, the higher the demand for energy. For agricultural production, the relationship is not always as straightforward since differences in products, crop growth phases and soil textures have different responses to the same weather factor.
• If financial institutions can offset the risk with these types of contract, they may be in better positions to expand credit at perhaps improved terms.
• Just as with the introduction of agricultural futures contracts to SA, weather derivatives will only be successful if their introduction is accompanied by a substantial educational process.