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Definition: Weather Derivative
Derivatives are the contracts which derive its value from an underlying asset. The underlying asset used here is the weather. This instrument can be used to hedge weather related losses. This is in contrast to the insurance cover used by the company which is effective in case of catastrophic events, while weather derivatives can be used on seasonal basis.
Farmers for example who are heavily dependent on weather can get into an contract whose price is determined by the amount of rainfall. If the weather turns out to be normal then the investor gets the premium and it the weather turns bad the farmer pockets the gain. Events such as a music show can be guarded against weather abnormalities. If the weather turns bad than less expected tickets would be sold and vice versa. The organizer can protect itself from higher losses by selling weather derivatives. Companies such as Enron has used it in the past.
Valuation : The method of valuation used is in stark contrast to the Black-scholes equation used to value derivatives. However few standardized are used in valuation :
a. Business pricing: They are based on the amount of losses borne by the company in case of weather abnormalities. The investor on the basis of his risk appetite and the user on his cost-benefit analysis determine the price.
b. Historical pricing: This is used to provide a rough estimate of the future based on past payout of the derivative. This a very simple approach.
c. Physical modelling: This is based on the output of numerous weather prediction model based on physical equation to predict the future events. One such prediction model is Ensemble forecasting which predicts the future states of a dynamic system based on different initial conditions.
d. Index modelling: We can model the index based on which the derivative are priced. Index can be modelled using historical data in statiscal time series model.
Weather Derivatives refers to a derivative financial instrument in which meteorological data such as temperature - is used as a basis product. Other indices such as precipitation are also used. Enron Corporation through its Enron Online unit was a major pioneer in weather derivatives. Although the first weather derivative was traded as early as 1996 by Aquila Corporation.
The first exchange traded weather futures contract was introduced by the Chicago Mercantile Exchange (CME) in 1999. It currently lists weather futures contracts covering 25 cities in the US, 11 in Europe, 6 in Canada, 3 in Australia and Japan. They are traded much like other types of commodity futures such as on Oil and Wheat etc. except that here the trade is done based on temperature levels. The buyer pays a premium for the option on temperatures.
The valuation of weather derivatives cannot be done through Black-Scholes model as the underlying asset is non-tradable (temperature) and hence it is priced using various methods such as Business pricing, Historical Pricing, Index modelling and Physical Modelling.
Differences between weather derivative and weather insurance:
• Weather Insurance – Low Probability, High risk events
• Weather Derivatives – High probability Low risk events
• Damage proof
• Contracts can be traded in secondary market
• Contracts are standardised
• Heating Degree Day: HDD (t) = max (65°-T(t),0)
• Cooling Degree Day: CDD (t) = min (T(t)-65°,0)
• Generally summed up over a month or a season
Variety of derivatives:
- Measurement location
- Asset type (HDD, CDD, precipitation etc.)
- Time period
- Strike value
- Tick size
• Success of trading weather derivatives is highly reliant on the simplicity of the products
• These products are highly needed for liquidity of market
• Trading weather derivatives in USA is connected with the liberalisation of energy industry and thus led to increased competition
• There is a need to manage risk of energy suppliers/traders.
• And also need to react to energy consumers needs