Managing Dairy Profit Risk Using Weather Derivatives

Weather conditions are a primary source of dairy production risk. Hot and humid weather induces heat stress, which reduces lactation. Heat abatement, such as ventilation, directly affects the temperature and humidity. Abatement can increase expected profit, but cannot eliminate the lost revenue caused by heat stress. Weather derivatives can reduce weather-induced profit risk and act as a substitute for abatement at the margin. We test the risk management value of weather derivatives in a utility-maximization framework. The result is that weather derivatives can expand the efficient portfolio frontier. Simultaneously using the weather derivatives and abatement equipment is more favorable than using either alone.