An economic investigation into the potential use of yield insurance futures and options in Ontario

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Nayak, Govindaray N.
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University of Guelph

Government intervention in crop insurance is justified on two grounds: first, existence of asymmetric information and second, high correlation of yield risk across insureds. Geographically extensive unfavorable weather events, such as droughts, and extreme temperatures etc., induce significant correlation among individual farm yields. This defeats insurers' efforts to pool crop loss risk across farms. Futures and options on crop yields offer a potentially viable alternative to crop insurance because such markets (if liquid) are designed for the allocation of highly correlated risks. The purpose of this study is first, to evaluate recently introduced yield insurance futures and options contracts for use in Ontario and second, to assess the possibility of using both price and yield futures to manage the revenue risk faced by Ontario producers. Risk is defined and measured using variance and semivariance. There are three main parts to this dissertation. The first part establishes the statistical and economic relationship between distant regional yield futures contracts and individual yields. The second part uses semivariance as a risk measure and proposes a methodology to derive the semivariance minimizing hedge. The third part addresses revenue risk management by developing a joint hedging model in price, yields and Canada/US currency exchange. The study's primary focus is on theoretical issues but empirical analysis is done to derive support to the theoretical results. The theoretical and empirical results indicate that risk (variance) reduction is most influenced by correlation between individual and futures yields. This implies that an Ontario yield-based index will be more useful than a distant region yield-based index to manage yield risk in Ontario. It is also shown that efficiency gains can be achieved by focusing on semivariance (down side risk) in hedging decision rather than variance. The simultaneous hedging model results indicate that revenue risk reduction is best achieved by hedging with yield, price, and currency futures rather than each individually or paired.

yield insurance, futures and options, Ontario, potential use, crop insurance