Weather Derivatives: Risk Management

Predicting rain doesnt 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

Probability 4.0% 5.0% 7.0% 9.0% 10.0% 12.0% 15.0% 12.0% 10.0% 8.0% 4.0% 3.0% 1.0% Average Inches of Snow 6 7 8 9 10 11 12 13 14 15 16 17 18 12 With Call 3,500,000 3,500,000 3,500,000 3,500,000 3,500,000 3,500,000 3,500,000 3,500,000 3,500,000 3,500,000 3,500,000 3,500,000 3,500,000 3,500,000 Without Call 3,000,000 3,000,000 3,000,000 3,000,000 3,000,000 3,000,000 3,000,000 3,500,000 4,000,000 4,500,000 5,000,000 5,500,000 6,000,000 3,465,000

Snowfall Call Option

Call Option Features
Removal Cost (Millions)
5.0 4.5 4.0 3.5 3.0 2.5 9 12 Inches of Snow 15 18 Hedged Costs

Period = Nov-Mar Strike = 12 inches Limit = 20 inches Tick= $250,000 Limit = $4,000,000 Price = $500,000

Unhedged Costs

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 Global Climate Cycles Urban Heat Island Effect

Trends

ENSO Cycles Forecasting

Phoenix CDD Data - Adjusted

Phoenix CDD Call Graph

3600 3400 3200 3000 2800 2600 2400 2200

19 49 19 54 19 59 19 64 19 69 19 74 19 79 19 84 19 89 19 94 19 99

Phoenix CDD Call - Impact of Data Adjustments

CDD Call Structure Period = Jun-Sept Strike = 3,200 Tick = $10,000 Limit = $2 mil

All Year Expected Loss

Based on Unadjusted Data:

$826,000

Based on Adjusted Data:

$1.3 mil

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