Alternative Hedging Strategies in Maize Production to Cope with Climate Variability and Change

Climate change with increasing climate variability is likely to alter risks in agricultural production. The effectiveness of using weather derivatives to hedge against drought risks for rain-fed grain maize production was investigated for current (1981-2003) and future (2070- 2100) climates in Switzerland. The climate change scenario was extrapolated from results of a regional climate model (HIRHAM4) based on the IPCC A2 emission scenario. In addition, a sensitivity analysis was performed by varying the mean and variance of the initial probability space for the seasonal precipitation sum. Profits and risks with and without hedging were compared using the analogy of the value-at-risk measure (VaR), i.e., a quantile-based measure of risk. A Monte Carlo chain composed of different models was used, with each model consisting of functions translating weather variables into the stochastic distributions for grain yield and economic returns. Depending on location, hedging reduced VaR to a variable degree under both current and future climatic conditions, with a considerable basis risk due to spatial heterogeneity of precipitation. The results also showed that hedging might provide a valid risk transfer since loading of 90 to 240% of the fair premium can be paid to obtain a hedged situation with improved outcomes relative to the business-as-usual reference. However, due to the uncertainty attached to climate scenarios and a strong bias in precipitation scenarios for the European alpine region, application of weather derivatives would require continuous re-equilibration and recalculation of the premiums. Depending on local conditions, the fair premium of a specific contract for hedging against weather risks in grain maize production may vary by a factor of two to four over the 70-year period considered. This represents a substantial uncertainty for both the underwriter (farmer) and the institution writing the contract.