The project will look at international models, as well the best way to deliver the product across Australia. NSW is hoping the Commonwealth and other states will take part in the project.
Deputy Premier and Minister for Regional NSW, John Barilaro, said NSW primary producers are facing one of the worst droughts in living memory.
"The NSW Government wants to make sure our farmers have the ability to endure the harsh conditions that Mother Nature can often throw their way," Minister Barilaro said.
Minister for Agriculture Adam Marshall said a national income protection scheme would be the best measure to help farmers combat drought.
"As this drought rolls on it's obvious we need to be looking at ways to roll out a product that would cover all producers - whether croppers, graziers or horticulturalists - against the devastating loss of income that comes with drought and other natural events," Minister Marshall said.
The NFF has welcomed the announcement.
"Drought continues to severely impact farmers and rural and regional communities across the east coast," NFF president Fiona Simson said.
"With the Bureau of Meteorology forecasting no rain in sight, and drought predicted to become more frequent and prolonged in future, we need long term solutions now.
"Farmers and agriculture-dependent communities need support to get through what could be another disastrous year in some parts of NSW and other parts of Australia," she said.
The NFF has long called for a comprehensive National Drought Policy that provides farmers and rural and regional communities with certainty as to the measures available to them to manage drought.
"The Policy needs to prioritise measures that build drought resilience, ensures collaboration between all levels of government and partnership with industry.
"This investment by the NSW Government is a major contribution to developing innovative ways to manage drought and the radical swings in income that accompany it."
Financial risk management products, from insurance to weather derivatives and forward contracting, are important tools in the range of measures farmers employ to manage risk.
There is considerable work needed, however, to develop these tools.
The NFF said it looks forward to working with its members, including NSW Farmers and Grain Growers, in taking the work forward.
More details on drought assistance can be found at: