strength, cold days, number of hours of sunlight, etc.. In all these cases, an index is made available (e.g., number of millimetres of rainfall in location X), and people can take a position in this index. Payouts, then, will follow the development of the index. For example, if a farmer sells rainfall futures, and rainfall falls below the index, he will receive X amount for each mm that the rainfall has fallen. Presumably, this will compensate him for all or part of the production loss that he suffered as a result of the rainfall deficit.
In principle, weather risk management instruments can allow farmers to obtain coverage against much of the “quantity” part of their revenue (revenue = quantity produced x price obtained), complementing their price risk coverage. But these markets are only just emerging, and even in the most developed market, in the United States, possibilities are still limited. Even if a market exists in a country, the problem of basis risk remains large: how well correlated are the production of a farmer in location Y and rainfall data in location X?
At least in the near future, as far as developing country agriculture is concerned, weather risk management is most likely to be used by those who are exposed to aggregate risk. For example, in India a micro-finance organization with an active agricultural loan portfolio, Basix, has used weather derivatives to manage the credit risk of its overall portfolio in a drought-prone region. Other than banks that wish to better manage their lending risks, input suppliers such as fertilizer companies or processors who depend on supply from a certain region could also act as aggregators, and lay off the aggregate weather risk on a futures or over-the-counter market.
The principal such tool is the average price option, also called Asian option. One would normally expect that such options fit best with the farmers’ pattern of sales: relatively small quantities spread out over a period of several weeks or a few months. A cooperative may bundle farmers’ deliveries for sale to traders, but the price is then normally based on an average of recent prices, not just the day’s price. Asian options are cheaper than exchange- traded options.
There are many other tools, some of which may well fit with a farmers’ association’s price exposure. Zero cost options combine the purchase of put options with the sale of call options, which implies that the producer is paying for the price insurance by giving up their potential gain from price increases above a certain level. In a modified version of this, participation options, he has some of the potential upside. Knock-out options, which are options that automatically disappear once a certain price level is reached, could be a possibility for cooperatives with a well-established reputation on international markets, who are able to sell forward long before the start of the harvest. For input supply programs, binary (digital) options can be a good fit (they provide for a single payment once a certain price level has been breached—so a fertilizer distributor could use it as a marketing ploy, selling on credit but with the proviso that the farmer does not need to reimburse if coffee prices fall below a certain level).
Price risk management can also be retailed under the guise of vouchers—similar, in a way, to lottery tickets. They could be sold on a stand-alone basis, or packaged together with other goods or services—for example, fertilizers. If such vouchers are distributed regularly, it is possible that an active secondary market is created, making it possible for farmers to chose themselves their optimal level of price risk management.