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Weather Derivatives:

Risk Management

Predicting rain doesn’t count;


Building arks does

Warren Buffett,
Australian Financial Review,11 March 2002.
AGENDA
 Introduction

 When to use it ?

 How to use it – Terminologies

 Pricing Models

 Indian Side
Introduction and
Importance
 In 1997 the first over-the-counter (OTC) weather
derivative trade took place, and the field of weather risk
management was born.
 The world's first exchange traded weather derivative
began trading on September 22, 1999 at the CME
 20% of the U.S. economy is directly affected by the
weather
 Weather risk is one of the biggest uncertainties facing
any business
 A mild winter ruins a ski season, dry weather reduces
crop yields, & rain shuts-down entertainment &
construction
 Till now Energy Companies are major player
Importance
 Companies whose earnings fluctuate wildly receive
unsympathetic hearings from banks and potential investors.

 As a tool to HEDGE; Not Correlated at all with trends in


Financial Market.

 Notional Value of $45 billion as of 2006 from $22 billion in


2005.

 In Asia, the number of weather contracts traded rose to 6,837


for the current year, compared to 1,940 in 2007-2008.

 A farmer's common complaint "Everybody talks about the


weather, but nobody does anything about it" will soon become
a thing of the past with weather derivatives
Tools available
 Weather Insurance

 Weather Derivatives (since 1997)

When to use what?


Weather Measure
“HDD and CDD”

They are the number of degree by which the average


temperature is below or above a base temperature

 Daily HDD = max(0, daily avg. temp – base temp)

 Daily CDD = max(0, base temp - daily avg. temp)


Types of Weather
Derivatives
 Swaps: Payoff = [Min {P($/DD)*Max(ST-X,0), h}]-
[Min {P($/DD)*Max(X-ST,0), h}]

 Collars: Payoff = [Min {P($/DD)*Max(ST-K1,0),


h}]-
[Min {P($/DD)*Max(K2-ST,0),
h}]

 Puts (floors): Payoff = P($/DD)*Max(X-ST,0)

 Calls (caps): Payoff = P($/DD)*Max(ST-X,0)


Applications: ICE CREAM
Example
 Problem: The municipality of Fort
Wayne, IN has spent $3,000,000 to
provide for snow removal for the
upcoming winter. This money will fund
the equipment and labor to remove 12
inches of snow. Because of overtime
rules, the municipality estimates that
every additional1/2 inch of snow leads
to an additional $250,000 of snow
removal costs.
Removal Costs With &
Without the Call
Inches of With Without
Probability Snow Call Call
4.0% 6 3,500,000 3,000,000
5.0% 7 3,500,000 3,000,000
7.0% 8 3,500,000 3,000,000
9.0% 9 3,500,000 3,000,000
10.0% 10 3,500,000 3,000,000
12.0% 11 3,500,000 3,000,000
15.0% 12 3,500,000 3,000,000
12.0% 13 3,500,000 3,500,000
10.0% 14 3,500,000 4,000,000
8.0% 15 3,500,000 4,500,000
4.0% 16 3,500,000 5,000,000
3.0% 17 3,500,000 5,500,000
1.0% 18 3,500,000 6,000,000

Average 12 3,500,000 3,465,000


Snowfall Call Option
5.0
Call Option Features

Removal Cost (Millions)


4.5 Unhedged Costs
Period = Nov-Mar
4.0
Strike = 12 inches
Limit = 20 inches 3.5
Tick= $250,000
3.0 Hedged Costs
Limit = $4,000,000
Price = $500,000 2.5
9 12 15 18

Inches of Snow

Solution: A Snowfall call option which pays $250,000 per 1/2 inch
of snowfall above a strike of 12 inches to a maximum of 20 inches
Existing Pricing Models
 Arbitrage – Free Pricing

 Actuarial pricing method

 Consumption Based Pricing


Alternate Pricing model
Apply Structure to Empirical Data

 NCDC Historical Database

 Adjust the Historical Data

 Apply Derivative Structure to


Adjusted Data
Data Adjustments

 Station Changes
 Instrumentation
 Location
 Trends
 Global Climate Cycles
 Urban Heat Island Effect
 ENSO Cycles
 Forecasting
Phoenix CDD Data -
Adjusted
Phoenix CDD Data Adjusted for Trend

3800

3600

3400

3200

3000

2800

2600

2400

2200

Original Adjusted
Phoenix CDD Call Graph
3600
3400
3200
3000
2800
2600
2400
2200
49

54

59

64

69

74

79

84

89

94

99
19

19

19

19

19

19

19

19
19

19

19
Phoenix CDD Call - Impact
of Data Adjustments
 CDD Call Structure All Year Expected
Loss
 Period = Jun-Sept
 Strike = 3,200  Based on
 Tick = $10,000 Unadjusted Data:
 Limit = $2 mil $826,000

 Based on Adjusted
Data:
Calculating the Payoff
 Fit a Probability Distribution to
Adjusted Data after simulation
 Apply the formula

Pr- expected payoff of CDD option;


Dpu- Dollars per unit;
rd- rate of interest;
t –time to expiration;
Str-strike;
CDDmax= Maximal payout/ Dpu+Str;
P(CDD)- frequency function.
Thank You