The weather premium in the U.S. corn market

• Author: Dermot J. Hayes,Keri L. Jacobs,Ziran Li
• Published date: 01 March 2018
• Date: 01 March 2018
• DOI: http://doi.org/10.1002/fut.21884

Received: 11 March 2017

|

Accepted: 3 September 2017

DOI: 10.1002/fut.21884

RESEARCH ARTICLE

The weather premium in the U.S. corn market

Ziran Li

1

|

Dermot J. Hayes

2

|

Keri L. Jacobs

3

1

School of Public Finance and Taxation,

Southwestern University of Finance and

Economics, Chengdu, Sichuan, China

2

Departments of Economics and Finance,

Iowa State University, Ames, Iowa

3

Department of Economics, Iowa State

University, Ames, Iowa

Correspondence

Ziran Li, School of Public Finance and

Taxation, Southwestern University of

Finance and Economics, 825 Gezhi

Building, Chengdu, Sichuan 611130, China.

Email: lizr@swufe.edu.cn

We show that the weather premium, an anecdotal phenomenon in the U.S. corn

futures market, can arise from a convex demand function. We further show that the

magnitude of the weather premium depends on the carryout and expected yield at

harvest. We use data from 1968 to 2015 to evaluate the accuracy of the December

futures price as a forecast of the harvest price. A predictable component in the forecast

error is consistent with the existence of a time-varying weather premium. We

demonstrate that a passive strategy of routinely shorting the corn December futures

does not provide an attractive risk-adjusted return.

KEYWORDS

bias in commodity futures, corn futures, predictive power, weather premium

1

|

INTRODUCTION

Participants in the U.S. corn futures market often refer to a “weather premium”or “weatherr iskpremium.”This premium, if it exists,

suggests that the price of the December futures contract in spring may over predict the actual harvest price because of a built-in

premium for accepting risks associated primarily with weather uncertainty. There is some evidence of this premium: over the last

50 years, the spring December futures price overestimated the realized harvest price by 4% on average. A predominant motivation for

the existence of weather premium is the suppositionthat a weather event that r esultsin a negative supply shock causes a larger increase

in price than the price reduction associated with a positive supply shock. The argument underlying this is the existence of a convex

demand function. While anecdotally this type of bias is believed toexis tand even influence trading strategies of hedgers, to the best of

our knowledge, the weather premium has not been formally defined and investigated empirically in the academic literature.

The goal of this paper is to formalize the concept of the weather premium vis-à-vis a demand curve and analyze whether and

to what extent the weather premium exists in the corn futures market. We derive comparative statics from the demand curve for a

commodity that relates the size of harvest and its variability with the magnitude of the weather premium. We show theoretically

that a convex demand curve alone will give rise to the weather premium, which we define as the difference between the expected

harvest price and the price given an average harvest.

We then explore empirically the forces believed to influence the weather premium, showing how asymmetry of the demand

curve for grains arises from storage, which causes the weather premium to be dependent on the level as well as the variance of the

expected supply of a commodity at harvest. We test empirically the comparative statics derived from a convex demand function

by analyzing forecast errors of the December futures contract for corn from 1968 to 2015. The results suggest there is a

predicable component of the forecast error that varies over time with the distribution of the expected supply, and this is consistent

with the existence of a weather premium. Further, recent corn yield realizations, a key determinant of the expected supply,

provide statistically significant explanatory power for the variations in the forecast errors. In an out-of-sample forecast

[Correction added on 20 October 2017, after first online publication: affiliation of Dr. Keri Jacobs has been updated to “Department of Economics, Iowa

State University, Ames, Iowa”.]

J Futures Markets. 2018;38:359–372. wileyonlinelibrary.com/journal/fut © 2017 Wiley Periodicals, Inc.

|

359