Comparative Analysis of Weather-Based Indexes and the Actuaries Climate IndexTM for Crop Yield Prediction and Weather-Derivative Pricing

Climate change poses significant challenges to the agricultural and financial sectors, affecting crop productivity and the overall financial stability. This study evaluates the robustness of the Actuaries Climate IndexTM (ACI), a relatively recent tool to measure the impact of climate change, by comparing its explanatory power to well-established weather-based indexes (WBIs) across two key sectors. In the agricultural context, the yields of three major crops are predicted using generalized statistical models and advanced machine learning algorithms with climate indexes as explanatory variables. To enhance model reliability and address multicollinearity among weather-related variables, the study also incorporates both principal component analysis and functional principal component analysis. A total of 22 models, each constructed with different sets of explanatory variables, illustrate the significant impact of wind speed and sea-level changes, alongside temperature and precipitation, on crop yield variability across six regions of the United States. For the financial market application, the analysis adapts the weather-derivative framework, as it is a critical instrument for energy companies, insurers, and agribusinesses seeking to hedge against weather-related risks. By analyzing the payoffs of derivative contracts that use WBIs and ACI components as underlying variables, the findings reveal that the ACI framework holds a strong potential as a comprehensive climate risk indicator, not only for the agricultural sector but also for the finance and insurance industries.