Applying a credit default swap valuation approach to price South African weather derivatives / Amelia Nadine Holemans

Most farmers in South Africa use standard insurance to protect their crops against natural disasterssuch as hail or strong winds. However, no South African insurance contracts exist to compensatefor too much or too little rain (although floods are covered), or which will pay out iftemperatures were too high or too low for a certain period of time for the relevant crop.Weather derivatives - which farmers may employ to ensure crops against adverse temperatures -do exist, but these are mostly available in foreign markets in the form of Heating Degree Dayscontracts and Cooling Degree Day contracts and are used chiefly by energy companies. SomeSouth African over-the-counter weather derivatives are available, but trading in these is rare andseldom used.The goal of this dissertation is to establish a pricing equation for weather derivatives specificallyfor use in the South African market. This equation will be derived using a similar methodologyto that employed for credit default swaps. The premium derived will be designed to compensategrape farmers from losses arising from two different climatic outcomes - in this case temperatureand precipitation. These derivatives will be region and crop specific and the formulation will besufficiently flexible as to allow for further climatic possibilities (which may be added at a laterstage).These weather derivative premiums will then be compared to standard crop insurance to establisheconomic viability of the products and recommendations will be made regarding their usage.The possibility of the simultaneous use of these derivatives and standard crop insurance for optimalcrop coverage will also be explored and discussed.