Crop Insurance as a Risk Management Strategy in Bangladesh

eplicate his position, the farmer could enter into a weather contract with the following
incremental payout P per unit index:
Therefore, his overall position would be:
∆P = X × H × a(I) × ∆I
∆Revenue + AP = - X × ∆Υ × H + X × H × a(I) × ∆I = 0
Producers may have contractual obligations to deliver a predefined amount of their farmed
product to a buyer at harvest time, with associated penalties if these obligations are not met.
In such a situation, it would be straightforward to quantify and structure a hedging product to
protect producers from these contractual costs in the event of weather related shortfalls in
production.
The Limit
Most weather contracts have a limit, which corresponds to the maximum financial payout or
recovery from the contract in a worst-case scenario, such as a complete crop failure. The
maximum payout can be set by either considering the value-at-risk for the producer in the
event of a total crop failure or by looking at historical index, production, and sales data to
find the worse-case scenario historically in order to establish a limit. Alternatively, a
producer may simply want to insure his production and input costs in order to recover these
outlays if the crop fails. If a producer’s production costs are $Z per hectare farmed, $Z will
therefore correspond to the maximum payout, the limit of the weather contract, for each
hectare the producer wishes to insure. The unit exposure P will therefore be as follows:
Figure 7.8: A weather contract for drought based on rainfall
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