Weather Derivatives: A Tool to Conquer Nature
Editor - CoolAvenues | September 25,2014 10:54 am IST
Hedging refers to a portfolio management technique that serves as a means of protection against some financial loss. To illustrate, let us suppose a mutual fund has invested in stocks and the fund manager expect the market to go down in the near-term.
The fund manager can minimize this perceived loss by “hedging” his portfolio in anticipation of the fall using an instrument called Derivatives.
A derivative product may be defined as “A financial contract whose value depends on a risk factor(s) of a single or a combination of assets”, such as
• The price of a bond, commodity, currency, share, etc.
• A yield or rate of interest
• An index of prices or yields
• Insurance data, such as claims paid for a disastrous earthquake or flood, etc.
In this category a new addition is Weather Derivatives. These provide companies with an option to hedge against the risk of weather fluctuations. Some of the weather conditions that a company can protect itself from are temperature, precipitation (rainfall and snowfall), wind speed, heat and humidity.
Weather derivative contracts were initiated by Enron in 1997. In the beginning, deals were all arranged as privately-negotiated over-the-counter transactions and were structured as protection against warmer or cooler than average weather in specific regions for the winter or summer seasons. This new market was initially led by the US Energy industry. Soon it expanded to address a wide array of weather risks faced by numerous other industrial sectors and to other countries like the U.K., Australia, France, Germany, Norway, Sweden, Mexico and Japan. Although most trading in the weather market is still Over-the-counter, standardized weather derivative contracts are now listed on the Chicago Mercantile Exchange (CME), the Intercontinental Exchange (ICE), and the London International Financial Futures and Options Exchange (LIFFE). Increasing trading volumes in these contracts is having positive impacts on market liquidity and price discovery.
Who needs weather derivatives?
Any company whose revenue is affected by weather has a potential need for weather derivatives. Some of these industries include
• Soft drinks and confectionery retailers
• Hotels and leisure industry
• Engineering and Construction industry
• Energy producers and distributors
• Insurance, Reinsurance companies
• Banks and financial institutions
• Breweries, pubs and restaurants
• Transport and distribution companies
Anatomy of a Weather Derivative
The trading mechanisms of weather derivatives involve the following components:
Reference Weather Station
All weather contracts are based on the actual observations of weather at one or more specific weather stations. Most transactions are based on a single station, although some contracts are based on a weighted combination of readings from multiple stations and others on the difference in observations at two stations.
The underlying index of a weather derivative defines the measure of weather which governs when and how payouts on the contract will occur. The most common indexes in the market are Heating Degree Days (HDDs) and Cooling Degree Days (CDDs) - these measure the cumulative variation of average daily temperature from 650F or 180C over a season and are standard indexes in the energy industry that correlate well with energy consumption.
A wide range of other indexes are also used to structure transactions that provide the most appropriate hedging mechanisms for end-users in various industries. Average temperature is another common index for non-energy applications, and some transactions are based on so-called event indexes which count the number of times that temperature exceeds or falls below a defined threshold over the contract period. Similar indexes are also used for other variables; for example cumulative rainfall or the number of days on which snowfall exceeds a defined level.
All contracts have a defined start date and end date that constrain the period over which the underlying index is calculated. The most common terms in the market are for specific seasons. However there has been an increasing volume of trading in one month and one week contracts as the market have grown. Some contracts also specify variable index calculation procedures within the overall term - such as exclusion of weekends or double weighting on specific days - to address individual end-user business exposures.
Weather derivatives are based on standard derivative structures. Key attributes of these structures are the strike (the value of the underlying index at which the contract starts to pay out), the tick size (the payout amount per unit increment in the index beyond the strike), and the limit (the maximum financial payout of the contract).
The buyer of a weather option pays a premium to the seller that is typically between 10% and 20% of the notional amount of the contract; however this can vary significantly depending on the risk profile of the contract. There is typically no upfront premium associated with swaps.