Weather Derivatives

Abstract

Weather is an uncertain force of the nature affecting many businesses. Insurance has been used as a traditional method to cover such vagaries of weather. The latest approach to transfer and hedge these risks is known as weather derivatives working in the capital market. But unlike the insurance sector these derivatives are not based on prices. They have volume or quantity as base and are not perfectly correlated with the losses experienced. Weather derivatives are developed to manage weather risks and form one of the fastest growing derivative markets. This is a convergence of the insurance and the financial market. This article aims to provide an overview of weather risks, weather derivatives, weather derivative market and optimal weather hedging with the consideration of basis risk (The risk created by the by the fact that the from the financial derivative is a function of weather pre-specified geographical which may not be identical to the location of the firm) and credit risks (The risk that the counterparty to the derivative contract may not perform).

Introduction

Business is exposed to many type of risk. Some are the predictable and controllable but some are not. The real problem is one of tackling the uncontrollable risks, and the most unpredictable risk factor till date is weather. All the business is exposed to this risk. It is reported that all businesses face up to 70 percent weather risk of some sort. The major businesses exposed to weather risk are construction, energy (power), entertainment, manufacturing, retail, travel, tourism, agriculture and many others. But the effect of weather on the agriculture and power sector is substantial and there is an indirect effect on the retail business. For instance, earnings of the power industry depend on the retail prices and the sales quantities of electricity, which in turn are affected by weather conditions. In an economy like India the risk increases manifold because of the undependable weather forecasting. The most popular method to offset these kinds of risk was primarily through price hedging mechanisms. This mechanism has ignored the concept of the volumetric risks which largely were left unhedged. The increasing competition due to the rapid globalization and opening up of the economies of various countries made it necessary for companies to hedge the volumetric risk caused by unexpected weather conditions. To meet this demand a new class of derivatives was created known as the "Weather Derivatives".

Weather derivative is a transaction through which payments from one party to another are made based on weather-related measurements typically provided by a national weather service or, in the case of Chicago Mercantile Exchange (CME) contracts, by MDA Federal/Earth Satellite Corporation. For the risk management, weather derivatives allow corporations to transfer a well-defined portion of their weather-induced profit volatility to a third party. The premium charged on the weather derivatives depend on number of factors including the future probability of certain weather events occurring for a given period from an historical and actuarial perspective, future forecasts and trends, and the level at which the customer wants protection to begin (deductibles). Weather derivatives allowed those businesses that are unfavorably affected by unexpected weather swings to handle this risk, in the same way that hedgers commonly use conventional financial derivatives to hedge their risks in interest rates, equities, and foreign exchange. Weather derivatives emerged in United States in 1997 following the deregulation of American energy and power industries. Since its inception in the late 1990s, the market for weather derivatives has grown steadily.

Among all the weather derivative transactions, temperature-related deals are the most prevalent, accounting for more than 80% of all transactions. The notional value of CME weather contracts has grown from US$2.2 billion in 2004 to more than US$36 billion through 2005. The customer base is still primarily comprised of energy companies, but the market materializes to be expanding. Although the impulsion of the weather derivatives market comes from the power and energy sectors, weather derivatives can be and have been used by other industries such as the retail business and the tourist industry. Despite the rapid growth of the weather derivatives market, the bid/ask spread is still large. There is not yet an effective pricing method and some key