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Risk and uncertainty in a water market will generate trading patterns that differ from those expected under conditions of perfect foresight. Although trades will occur based on differences in VMPs of water in both markets, they will also be generated by differences in risk. Some farmers will choose to reduce relative risk by purchasing additional water rights whereas others will hold few rights and rely on the spot market to meet their needs in dry years. Since spot markets are riskier than permanent rights markets, farmers who are better able to bear risk are more likely to participate in the spot market than those who are not. Farmers who face less risk will be sellers in both markets whereas farmers who face more risk will be buyers. Perennial crop producers with high VMPs of water and who face the highest risk from water deficits, will not participate in spot markets and will tend to be only buyers in permanent rights markets in an attempt to insure against potential losses in the future productivity of their capital stock of perennial crops.
Using data on short-term leasing and permanent rights transactions collected from over 300 farmer surveys during the 1996/97 growing season, water market participation decisions for spot and permanent rights markets are modeled in a discrete choice framework. Results support the hypothesis that risk has a significant effect on which market a farmer will participate in and in whether they will be demanders or suppliers of water or water rights.
