A Dynamic Programming Framework for Using Weather Derivatives to Manage Dairy Profit Risk

Dairy farms confront unique risks from weather conditions. Hot and humid weather induces heat stress, which reduces both the quantity and quality of dairy production. Traditional heat abatement technologies control the environment through ventilation, misting or evaporative cooling. Adoption of abatement equipment, however, is hindered by its high initial cost and possibly long payback period, especially for smalland medium-scale firms. Moreover, the abatement equipment is only seasonally useful as a fixed asset whose price rises with efficacy. Weather derivatives provide an alternative method of dairy farmers’ risk management. Since abatement equipment can be used for many years once installed, and its maintenance costs will increase and efficacy will decrease with age, a decision that must regularly be made by a dairy farmer is when to maintain his abatement equipment and when to replace it with a new one. The decision affects both current and expected future revenues. Considering that weather derivatives can be purchased periodically, the objective of this study is twofold: first, to test the risk management value of weather derivatives for dairy plant operations; second, to examine how weather derivatives can affect dairy producers’ abatement equipment decisions. In this study, we employ a dynamic programming framework to study the case that a representative dairy farmer maximizes his long-run utility using weather derivatives and abatement equipment.