l8 Weather Derivatives

Lecture 8: Weather Derivatives
Derivatives in Corporate Finance

Alonso Pea
SDA Bocconi, Intermediazione Finanziaria e Assicurazioni
Copyright SDA Bocconi, protocollo xxxx
Contents
Part 1:
Introduction
Part 2:
Examples of Weather Derivatives
Part 3:
Modelling Weather Derivatives
Part 4:
Case Study: United Nations World
Food Programme
Copyright SDA Bocconi 2007
2 2
Part 1: Introduction
Introduction
Weather Derivatives*
Weather Risk
The study of derivatives entails understanding risk.
We have covered a lot of different types of risks, the
main ones being market risk arising from interest rates,
exchange rates, commodity prices, and stock prices, and
also credit risk.
In this lecture we introduce derivatives on one of the

most interesting and important sources of risk: the
weather.
*These selections are from: Don M. Chance, Essays in Derivatives: Risk-Transfer
Tools and Topics Made Easy, Wiley, 2 edition, 2008. Essay 20.
8 8
Introduction
Weather Derivatives
Weather and Business

It is not difficult to think of the types of businesses
that benefit or are hurt by the weather.
Even a child's lemonade stand benefits from hot
weather.
Imagine beer and soda companies benefiting from
hot weather and companies that sell hot chocolate
and cocoa benefiting from cold weather.
9 9
Introduction
Weather Derivatives
Weather and Business

Ski resorts, vacation properties, the travel industry,
and clothing manufacturers are good examples of
companies whose business is partially and in some
cases primarily driven by the weather.
On a larger scale, public utilities and airlines are

heavily influenced by the weather.
The derivatives industry has recognized the
importance of weather by creating a class of products
known as weather derivatives.
1010
Introduction
Weather Derivatives
Weather data
Weather is an excellent variable on which risk can be
measured.
Weather is typically a highly quantifiable variable. In
fact, we are inundated with information on weather,
and virtually every adult and many children have a
modest understanding of it.
Statistical information is abundant, and lengthy
series of historical data exist on temperatures and
precipitation for localities all over the world.
1111
Introduction
Weather Derivatives
Weather data
Internert sites:
www.weather.com
weather.yahoo.com
it is a relatively simple task to obtain qualitative and
quantitative information on weather anywhere on the
planet. Insurance companies, which have provided policies
against weather-related damage for a long time, have
extensive information about the historical consequences of
severe weather.
1212
Introduction
Weather Derivatives
Weather data: temperature

The derivatives industry uses temperature as the
underlying of various contracts by means of two related
concepts: the heating degree-day (HDD) and the cooling
degree-day (CDD).
A heating degree-day is the number of degrees the

average temperature in a given day is below 65 degrees
Fahrenheit (18.33 Celsius). A cooling-degree day is the
number of degrees the average temperature in a given
day is above 65.
1313
Introduction
Weather Derivatives
If the average temperature in a day is 63 degrees,

the weather is measured as two heating degreedays. If the average temperature in a day is 67
degrees, the measure is two cooling degree-days.
A heating-degree day is, thus, a rough proxy for the
necessity to provide heat to obtain a comfortable
temperature, while a cooling degree-day is a rough
proxy for the necessity to provide coolness to obtain a
comfortable temperature.
1414
Introduction
Weather Derivatives
The notion of a heating or cooling degree-day provides a reasonable

underlying for weather derivative contracts.
Consider one six-month call option on cooling degree-days.
Let us say the buyer expects that the average temperature over the
next month (assume 30 days) will be 72 degrees, which is 7 cooling
degree-days on average. Then as a rough choice for the exercise
price, the buyer chooses 210 i.e. 30 x 7 = 210.
1515
Introduction
Weather Derivatives
The buyer pays the premium and receives a call option

that will pay at expiration a certain amount of money,
call it m, for every cooling degree-day over 210.
If the total number of cooling degree-days is less than
210, the option expires out-of-the-money.
If the buyer is interested in benefiting from lower-thanexpected temperatures, she would buy a put on
heating degree-days and benefit if the number of
heating degree days is lower than the chosen strike.
1616
Introduction
Weather Derivatives
Of course, determining m is the really difficult part.

The option buyer needs to know what financial loss
she expects on her business for each degree above 65
is the average temperature.
These estimates, however, should be fairly well
understood by anyone in business. Indeed, the child
with the lemonade stand probably knows to make a
few more liters of lemonade on those hot days and a
few less on cooler ones.
1717
Introduction
Weather Derivatives
Other forms of weather derivatives have been created

on such measures as rainfall and snowfall.
Dealers that make these markets typically have an

expertise in these markets.
Often this expertise is purchased by buying another
company or by hiring personnel, such as weather
experts.
1818
Introduction
Weather Derivatives
While most weather derivatives contracts are over the

counter, exchange-traded weather derivatives have existed
since the first ones were launched in 1999 at the Chicago
Mercantile Exchange (CME).
These futures and options on futures are based on average
temperatures in 18 U.S. and 15 non-U.S. cities.
The CME has also offered futures and options on futures on
an index of hurricane intensity, the number of days of frost,
and the number of days of snowfall.
1919
Introduction
Weather Derivatives
In spite of great efforts, however, the CME contracts have not

garnered much volume.
A few years ago the Chicago Board of Trade offered derivatives
on insurance claims arising from hurricanes and
earthquakes.
These contracts drew a great deal of acclaim and attention, in
particular from academics keen on deriving pricing formulas.
But after all was said and done, these contracts did not draw
much actual trading volume.
2020
Introduction
Weather Derivatives
While some tout the weather and environmental derivatives

markets as innovative and successful, I can agree only on the first
point.
They certainly are innovative, striking at the very heart of certain
significant risks encountered by many businesses. Nonetheless,
their innovative nature has in some sense been their bane.
Weather derivatives may be innovative, but they are completely
out of the traditional box of derivative products and therein lie
some problems.
2121
Introduction
Weather Derivatives
Pricing weather derivatives typically occurs in a much

more challenging manner.
Usually the underlying variable and its financial consequences
are forecasted, and a price is based on a discounting of the
expected payoffs.
Pricing methodologies are discussed later.
2222
Part 2: Examples
Examples
Corporate users
1997: the first widely publicised deal in the US took place

between Enron and Koch Energy, referenced to the Milwaukee
winter season; in September 1998, the first European deal
between Enron and Scottish Power was made.
1999: Canadian snowmobile maker Bombardier entered into a

snowfall contract with Enron. Bombardier would pay a
US$1,000 rebate to customers if snowfall levels did not reach
half that of the previous three years. It funded this potential
liability by purchasing snowfall digital floors structured in each
major market where the promotion was offered (44 cities).
2424
Examples
Corporate users
2001: London-based The White Swan pub entered into a

temperature contract with SocGen. Payment was triggered
by the number of cold Fridays and Saturdays during the
April-July period. In particular, the pub would receive
compensation if there are too few such days where the
temperature was above 14C in April and 18C in May, and if
there are too many such days where the temperature was
below 18C in June and 20C in July. White Swan estimated
that it stood to lose in excess of 15,000 per day that was
too cold to drink outside.
2525
Examples
Corporate users
2001: the city of Sacramento in California entered into a

precipitation contract with Aquila Energy. During droughts,
Sacramento was to get less of its electricity from hydroelectric
dams and pay higher prices for power on the open market. To
ease the pain of high-cost droughts, the Sacramento
Municipal Utility District (SMUD) entered a five-year contract
with Aquila.
2626
Examples
Corporate users
2001: Japan's Imaoka Corporation, a manufacturer of sore

throat lozenges, was one of the first companies to purchase
a weather derivative referenced to humidity, aimed at
protecting revenues in case of an unusually humid winter. For
Imaoka, sales often drop during the country's hot summer
months (the soaring humidity levels lessening incidences of
dry raspy coughs among the Japanese population).
2727
Examples
Corporate users
2002: Gut Apeldor golf club in Hennstedt, Germany, bought

a precipitation derivative that covered it from the risk of heavy
rain keeping golfers away (the weather in 2001 had been
miserable in that respect). The managers of the club decided
that they could put up with 50 rainy days from May to
September.
2828
Examples
Corporate users
2004: Corney & Barrow (C&B), which owns a: chain of

wine bars in the City of London, has closed a weather
derivatives deal with US energy giant Enron - the first such
undertaking by a non-energy company in the UK. The deal
was brokered by Speedwell Weather, a division of the UKbased bond software company Speedwell Associates.
2929
Part 3: Modelling
Modelling
Pricing weather derivatives
The lack of a single universal pricing model is a major

hurdle to the growth of the weather derivatives market.
It prevents participants from talking in the same language,
with each market maker essentially developing its own
pricing methodologies (which they, predictably, may not be
too willing to share with outsiders).
3131
Modelling
If a generally recognized pricing model were developed,

this could greatly improve market transparency and
would most likely enhance the number of entrants.
Just as the Black-Scholes breakthrough has been a key
driving factor of the explosive growth experienced by, among
others, the equity and currency options markets in the last 30
years, the weather market needs a common reference.
3232
Modelling
Why is it difficult to come up with a standard weatherderivatives pricing formula?

Plainly stated, because the Black-Scholes framework
cannot be used in this context.
While Black-Scholes modeling may be the standard approach
for options pricing in many other derivatives markets, applying
it to weather derivatives is hazardous because there is no
underlying tradable asset.
3333
Modelling
Another obstacle lies in the fact that the mathematics behind

Black-Scholes cannot be applied to the weather market.
Black-Scholes assumes that the underlying follows a random
walk without mean reversion where the volatility increases
with time.
In practice, weather shows mean-reverting tendencies
(tendencies to go back to its historical levels) and is
reasonably predictable, at least in the short term.
Black-Scholes can be modified to take into account meanreversion.
3434
Modelling
In light of these modeling difficulties, practitioners have opted

for two more hands-on: historical analysis and simulation.
Historical analysis, or "burn analysis", makes use of past
weather data to determine the fair value of the option. This
method is quite straightforward, needing only the collection of
historical time series and calculating what would have been
the payoff for a particular option on each past date. The price
of the option should then equal the average of all those
payoffs.
3535
Modelling
A drawback associated with burn analysis is that it is

totally data-dependent, that is, it makes a difference how
far back in time we go to calculate the average historical
payoff of the option.
Using, say, 10-years data will most likely yield very different
results from using 50-years data. A recent study of New York
City's weather derivatives market found the following
diverging figures for CDD, (three summer months) and
heating HDD, (three winter months), depending on the time
series considered.
3636
Modelling
Monte Carlo simulation seems to be the most commonly used

method for pricing weather derivatives.
It entails generating, with the help of a computer, a large
number of simulated random future weather scenarios to
determine possible option payoffs.
The option premium would then be the discounted average of
all those possible payoffs.
3737
Modelling
The drawback associated with simulation is, of course,

how to generate the future scenarios in the first place.
The answer lies in choosing an appropriate process for
the underlying (temperature changes beyond an index,
rainfall, wind speed, etc). Temperature is mean reverting
and not a random walk (volatility stays within a
reasonable range through time)
Probabilistic process used for simulation purposes should

take those aspects into account.
3838
Part 4: Case Study
Case Study
UN World Food Programme
Source: http://www.wfp.org/node/5
4040
Case Study
ADDIS ABABA The United Nations

World Food Programme announced today
that AXA RE has been awarded the
world s first insurance contract for
humanitarian emergencies. The contract
provides US $7 million in contingency
funding in a pilot scheme to provide
coverage in the case of an extreme
drought during Ethiopia s 2006
agricultural season.
4141
Case Study
The humanitarian emergency insurance

contract might, in the future, offer us a
way of insuring against these massive
losses before they spell destitution for
millions of families,
said Morris.
As a worldwide leader in Financial
Protection and one of the pioneers of
weather cover through its subsidiary AXA
RE, AXA is happy to provide its financial
4242
Case Study
This contract heralds the beginning of what

may be an entirely new way of financing
natural disaster aid, said Richard Wilcox,
Director of Business Planning at the World
Food Programme . With this pilot,
developed together with the World Bank
Commodity Risk Management Group, we
are testing whether it is possible to insure
against the devastation
caused by extreme drought.
4343
Case Study
the likelihood of widespread crop

failure. While the experimental pilot
transaction only provides a small amount
of contingency funding, the model has
been designed on the basis of the
potential losses that 17 million poor
Ethiopian farmers risk should an extreme
drought arise.
The policy complements recent UN
4444
Case Study
Some disasters especially conflict and

displacement are harder to predict and
faster to unfold, so we will continue to
need untied contingency funds. Risks
such as drought, however, can also be
managed effectively under the type of
contract we have just signed with AXA
Re , explained Wilcox.
Transferring weather risks from poor
countries like Ethiopia into the
4545
Case Study
The portfolio effect of bringing

emergency aid into the international risk
markets is a win- win for developed and
developing countries. Wit h this deal
WFP is making a bold move towards
more equitable and effective international
risk management , said Robert Shiller,
Professor of Financial Economics at Yale
University and author of The New
Financial Order: Risk in the
21st
4646
Case Study
We have shown that the reinsurance

sector can have an important role to
play in effective financing for
responses to natural disasters in
developing countries.
Now the
industry itself should take up the
challenge to provide effective products
to developing countries and the aid
community.
4747
Case Study
References:
WFP is the world's largest humanitarian
agency: each year, we give food to an
average of 90 million poor people to meet
their nutritional needs, including 61
million hungry children, in at least 80 of
the world's poorest countries. WFP -- We
Feed People.
4848

l8 Weather Derivatives

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Lecture 8: Weather Derivatives

Derivatives in Corporate Finance

Copyright SDA Bocconi, protocollo xxxx

Copyright SDA Bocconi, protocollo xxxx

Copyright SDA Bocconi, protocollo xxxx

Copyright SDA Bocconi, protocollo xxxx

Copyright SDA Bocconi, protocollo xxxx

Copyright SDA Bocconi, protocollo xxxx

In this lecture we introduce derivatives on one of the

Copyright SDA Bocconi, protocollo xxxx

Weather and Business

Copyright SDA Bocconi 2007

Copyright SDA Bocconi, protocollo xxxx

Weather and Business

On a larger scale, public utilities and airlines are

Copyright SDA Bocconi, protocollo xxxx

Copyright SDA Bocconi, protocollo xxxx

Copyright SDA Bocconi, protocollo xxxx

Weather data: temperature

A heating degree-day is the number of degrees the

Copyright SDA Bocconi, protocollo xxxx

If the average temperature in a day is 63 degrees,

Copyright SDA Bocconi 2007

Copyright SDA Bocconi, protocollo xxxx

The notion of a heating or cooling degree-day provides a reasonable

Copyright SDA Bocconi 2007

Copyright SDA Bocconi, protocollo xxxx

The buyer pays the premium and receives a call option

Copyright SDA Bocconi 2007

Copyright SDA Bocconi, protocollo xxxx

Of course, determining m is the really difficult part.

Copyright SDA Bocconi 2007

Copyright SDA Bocconi, protocollo xxxx

Other forms of weather derivatives have been created

Dealers that make these markets typically have an

Copyright SDA Bocconi 2007

Copyright SDA Bocconi, protocollo xxxx

While most weather derivatives contracts are over the

Copyright SDA Bocconi 2007

Copyright SDA Bocconi, protocollo xxxx

In spite of great efforts, however, the CME contracts have not

Copyright SDA Bocconi 2007

Copyright SDA Bocconi, protocollo xxxx

While some tout the weather and environmental derivatives

Copyright SDA Bocconi 2007

Copyright SDA Bocconi, protocollo xxxx

Pricing weather derivatives typically occurs in a much

Copyright SDA Bocconi 2007

Copyright SDA Bocconi, protocollo xxxx

Copyright SDA Bocconi, protocollo xxxx

1997: the first widely publicised deal in the US took place

1999: Canadian snowmobile maker Bombardier entered into a

Copyright SDA Bocconi 2007

Copyright SDA Bocconi, protocollo xxxx

2001: London-based The White Swan pub entered into a

Copyright SDA Bocconi 2007

Copyright SDA Bocconi, protocollo xxxx

2001: the city of Sacramento in California entered into a

Copyright SDA Bocconi 2007

Copyright SDA Bocconi, protocollo xxxx

2001: Japan's Imaoka Corporation, a manufacturer of sore

Copyright SDA Bocconi 2007

Copyright SDA Bocconi, protocollo xxxx

2002: Gut Apeldor golf club in Hennstedt, Germany, bought