Martin Kusy

Canadian Ice Wine Production: A Case for the Use of Weather Derivatives

Weather derivatives are a relatively new form of financial security that can provide firms with the ability to hedge against the impact of weather related risks to their activities. Participants in the energy industry have employed standardized weather contracts trading on organized exchanges since 1999 and the interest in non-standardized contracts for specialized weather related risks is growing at an increasing rate. The purpose of this paper is to examine the potential use of weather derivatives to hedge against temperature related risks in Canadian ice wine production. Specifically we examine historical data for the Niagara region of the province of Ontario, Canada, the largest icewine producing region of the world, to determine an appropriate underlying variable for the design of an option contact that could be employed by icewine producers. Employing monte carlo simulation we derive a range of benchmark option values based upon varying assumptions regarding the stochastic process for an underlying temperature variable. The results show that such option contracts can provide valuable hedging opportunities for producers, given the historical seasonal temperature variations in the region. (JEL Classification: G13, G32, Q14, Q51, Q54)

Climate Change and the Potential Use of Weather Derivatives to Hedge Vineyard Harvest Rainfall Risk in the Niagara Region

The widespread recognition of current and impending climate change has led to the examination of possible impacts and potential adaptation strategies to deal with the prediction of increased variability of weather. Viticulture in particular faces a myriad of weather-related risks that could increase significantly with climate change. In addition to changes in agricultural practices, the use of financial solutions must also be sought in order to deal with the impending economic risks. Weather derivative contracts are a growing market that provide for the hedging of many of the financial risks due to weather. Although their use is widespread and increasing, their adoption by the agricultural sector, including viticulture, has been relatively slow. Using the Niagara region of Canada, we provide an example of how a weather contract can be designed to hedge the financial risk of a critical weather-risk factor common in viticulture, that of excessive rainfall during the harvest season. The variability of rainfall in the Northern Hemisphere has been predicted to increase with climate change and if weather-related risks intensify, weather contracts could prove to be useful tools for the viticulture industry.

A comparison of Bayesian, Hazard, and Mixed Logit model of bankruptcy prediction

The purpose of this study is to examine the impact of the choice of cut-off points, sampling procedures, and business cycles on the forecasting accuracy of bankruptcy prediction models. A misclassification can result in an erroneous prediction resulting in prohibitive costs to firms, investors, and the economy. A salient feature of our study is that our analysis includes both parametric and nonparametric bankruptcy prediction models. A sample of firms from the Bankruptcy Research Database in the U.S. is used to evaluate the relative performance of the three most commonly used bankruptcy prediction models: Bayesian, Hazard, and Mixed Logit. Our results indicate that the choice of the cut-off point and sampling procedures affect the rankings of the three models. We show that the empirical cut-off point estimated from the training sample result in the lowest misclassification costs for all three models. When tests are conducted using randomly selected samples, and all specifications of type I costs over type II costs are taken into account, the Mixed Logit model performs slightly better than the Bayesian model and much better than the Hazard model. However, when tests are conducted across business-cycle samples, the Bayesian model has the best performance and much better predictive power in recent business cycles. This study extends recent research comparing the performance of bankruptcy prediction models by identifying under what conditions a model performs better. It also allays the concerns for a range of users groups, including auditors, shareholders, employees, suppliers, rating agencies, and creditors’ with respect to assessing corporate failure risk.

Hedging Adverse Bioclimatic Conditions Employing a Short Condor Position

Weather derivatives are a relatively new form of financial security, providing firms with the ability to hedge the impact of weather related risks to their activities. Participants in the energy industry have employed standardized temperature contracts trading on organized exchanges since 1999, and the availability and use of non-standardized contracts designed for specialized weather related risks is growing dramatically. The primary goal of this paper is to consider the potential design and use of a weather contract to hedge the risks faced in viticulture as measured by bioclimatic indices. Specifically we examine the Winkler and Huglin bioclimatic indices over a 43 year period for the Niagara region of Ontario, Canadas largest wine producing region, and identify a mixed jump diffusion stochastic process for cumulative growing season index values. We then employ Monte Carlo simulation to derive a range of benchmark prices for a “short condor” contract employing the Huglin index as the underlying variable. The results show that valuable hedging opportunities can be provided by such contracts. (JEL Classification: G13, G32, Q14, Q51, Q54)

THE EFFECT OF PROJECT RISK ON CAPITAL RATIONING UNDER UNCERTAINTY

Abstract The purpose of this paper is to investigate the effect of project risk on capital rationing with uncertain budgetary constraints. We reflect project risk by the standard deviation of cash flows. The problem is formulated in a stochastic linear programming with simple recourse (SLPSR) framework. In a sample problem, we vary the level of project risk and allow the probability distribution for the right-hand side constraints to be either symmetric or left skewed. We demonstrate that SLPSR yields superior solutions to an equivalent deterministic formulation and that risk aside, the borrowing rate is an important factor in determining the optimal solution vector. Moreover, we show that low project risk can compensate for higher borrowing costs and that the presence or absence of probability distribution asymmetry may not be an important issue.

The potential use of weather derivatives in the viticulture industry.

The increasing availability of specialized weather contracts represents an interesting opportunity for many producers to hedge the significant risks they may face due to adverse weather conditions. In this paper we have considered some of the major production risk factors due to weather, faced by the viticulture industry, and the potential weather contracts that could be employed to mitigate losses. Other important applications of weather contracts also exist in the marketing and tourism side of the viticulture industry. Sales at the cellar door for example may be reduced by adverse weather conditions over the typical wine tourism season. Again weather contracts can be useful in mitigating such losses in revenue. Finally recent studies of the impact of global warming indicate that weather conditions will be difficult to predict and will be associated with greater volatility in the future, making the use of weather contracts all the more valuable.

Corporate Social Responsibility, Corporate Governance, and Managerial Risk-Taking

This paper investigates the association between corporate social responsibility (CSR) and managerial risk-taking, as well as the differences in governance structure that affect this association. Using a sample of US public firms, we find that firms with strong CSR records engage in higher risk-taking. Furthermore, we find that accounting for differences in governance structure substantially accentuates this relationship. Prior literature establishes that high managerial risk-tolerance is necessary for the undertaking of risky yet profitable investment decisions. Thus, these findings suggest that CSR, rather than being a waste of scarce corporate resources, is instead an important aspect of shareholder value creation. They contribute to the debate on CSR by documenting that corporate risk-taking is one mechanism among others through which CSR maps into higher firm value.

Mutual Fund Fees, Performance, and Governance Structure in Canada

Taking advantage of the unique Canadian setting where two governance mechanisms coexist, this study empirically examines the impact of the presence of the board of directors, as an internal governance mechanism, on fees and performance of mutual funds. Furthermore, the impact of the board structure on fees and performance of corporate class funds is also analyzed. We find that corporate class funds, which have a separate board of directors for the fund, charge higher fees than trust funds. However, corporate class funds deliver superior performance that more than compensate for their higher fees. For corporate class funds, we find that a board with smaller size, CEO duality, and higher percentage of independent directors is more likely to charge lower fees. In addition, more independent boards are strongly associated with higher fee-adjusted performance. Our study provides valuable guidelines for Canadian investors and regulatory agencies.