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Weather Derivatives: Hedging on Mother Nature

Apr 19, 2012 || Adam Clements || 1Comment

For some industries, the weather plays a significant role in determining revenue. Unexpected weather events can often cause significant financial losses. For instance, a drought can yield a severe impact on an agribusiness’ amount and quality of produce; unseasonably mild winters can similarly diminish the profit margins of utility companies. So, how can companies – particularly those at the mercy of Mother Nature – protect themselves against the elements and limit their exposure to financial risk?

Increasingly, companies have been managing weather risk by using derivatives, which provide the means for businesses to protect themselves against adverse financial affects that are due to variations in climate. According to industry body, the Weather Risk Management Association, trading volume of weather derivatives in 2010-2011 increased by 20 percent  on the previous year.

How it Works

Derivative contracts generally represent a contract to trade a specified quantity of an underlying asset, at an agreed price and time. By making a payment to a separate company that will assume the financial weather risk for them, organizations are buying a type of insurance: the company assuming the risk will pay the purchaser a pre-set amount of money that will correspond to the loss or cost increase caused by the disruptive weather. As such, risk exposure can be managed in a wide range of settings.

Weather derivatives derive their value from climatic conditions such as temperature, snowfall, hurricanes or rainfall. An important set of contracts traded at CME Group are temperature-based futures contracts. Contracts are offered for trade based on the temperature across a range of U.S., European and Australian cities such as Brisbane, Sydney and Melbourne.

The most common of these contracts come in the form of either Heating Degree Day (HDD) or Cooling Degree Day (CDD) contracts. The payoff of these contracts is based on the cumulated difference in daily temperatures relative to 18⁰C (about 64⁰F) over a fixed period such as a month. The fixed level of 18⁰C is the temperature at which the energy sector believes little heating or cooling occurs in households. The buyer of a HDD or CDD contract benefits from a positive payoff if cumulative temperature is below or above a specified level. While this nomenclature may seem counter-intuitive, heating (or cooling) occurs when temperatures are lower (higher).

Major participants in this market include utilities and insurance companies, whose costs and or revenues are dependent upon weather conditions. In an Australian setting, an electricity supplier normally provides its customers with electricity at a fixed price irrespective of the wholesale price in the National Electricity Market. However, the wholesale price of electricity can fluctuate wildly with extreme weather conditions. CDD contracts can provide a hedging tool for such fluctuations in electricity prices in the wholesale market during periods of extremely high temperatures. Similar arguments apply in the northern hemisphere, where utilities face risk from increased demand during periods of low temperatures and hence HDD contracts are a natural hedging tool.

Pricing Weather

Futures on traditional assets such as stocks, bonds, agricultural and most energy products are priced under the cost of carry approach. The logic of this approach is that there are two alternatives for obtaining the asset in question at some point in the future. These are either, borrow to purchase it now and store the asset, or agree to purchase the asset at that later date via a futures contract. Under the absence of arbitrage, the cost of both approaches should be equivalent. Hence the current cost of a futures contract is related to the current price of the asset and the cost of borrowing and storing the asset. This arbitrage-free valuation approach is a simple yet common method for pricing many financial securities.

Weather derivatives have also gained research attention in academic circles as they represent a unique pricing problem. The cost of carry method is based on the possibility of storing, or holding the underlying asset.  However, in the case of weather contracts such as HDD or CDD, the underlying asset is not storable in any meaningful way.

As such, the cost of carry approach is not relevant and pricing is based on a discounted value of the payoff from the futures contract. A statistical model is required to generate the possible range of outcomes that the underlying weather index may take and subsequent payoffs ensuing from the derivatives contract. The discount rate will be market determined given the prices for contracts that the market will bear.

Weather derivatives are of great economic importance in that they allow participants to manage a very specific form of risk. While weather futures contracts currently make up a relatively small proportion of trading in derivatives markets, it is a sector that is experiencing rapid growth – particularly as more companies recognize the correlation between weather and profit.

This is an edited version of an article originally published at The Conversation.