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Derivatives For All Seasons

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Derivatives For All Seasons


By Ronn Mullins, Insurance editor

Ronn Mullins is the Insurance Editor for World-Generation


and a Member of the Class of 2008.
Everybody talks about the weather, Mark Twain observed, but nobody
does anything about it. True, nothing can alter the path or culmination
of weather, but now with weather derivatives, the sharp sting can be
lessened from the random effects of weather. These weather
derivatives are especially applicable for companies supplying energy
and those using it.
Simply, a derivative contract identifies a peculiar financial instrument
that has no value in and of itself, but derives its value from assets or
data that support it such as stocks, bonds, currencies, commodities, real estate, even weather.

Weather derivatives first appeared more than a decade ago when before the warm winter
brought on by El Nino in 1997-1998, Aquila Energy executed a weather option for Consolidated
Edison in New York that was embedded in a power contract.
Today, demand for weather derivatives continues to be strong worldwide, according to a survey
published by the Weather Risk Management Association which was conducted by Price
Waterhouse. The 2007 industry survey shows that the total number of contracts traded
worldwide both over-the-counter (OTC) and on the Chicago Mercantile Exchange (CME) -- was
730,087 for the period April 2006 through March 2007. Reflecting a shift from seasonal to
monthly contracts on the CME, the notional value of contracts traded during 2007 dropped to
$19.2 billion from 2006s record of $45.2 billion. Still growth has been substantial. In 2005 the
total value of contracts was $8.4 billion; in 2004, a mere $4.6 billion.
The basic trade inherent in weather-related risk management products is indexed on the
Heating Degree Day (HDD), a widely used measure for the relative "coolness" of the weather in
a given region during a specified period of time. HDDs are calculated using temperature data
provided by the National Weather Service. For any given day, HDDs are calculated as the
greater of (1) zero or (2) 65 degrees Fahrenheit less the midnight to midnight average of the
high and low temperatures for the day.
A Derivative for All Seasons

Industries that use weather derivatives are primarily companies in energy-related businesses.
Weather derivatives can hedge against too high temperatures for one industry and too low for
another. For natural gas and propane/heating oil companies, a very important factor
determining profit or loss for the company is the severity and duration of the winter. Warm
winters can seriously affect the financial results of these companies, as the volume of natural
gas and heating oil that is consumed during the winter season to a great extent determines
their sales revenue and profits. Thus natural gas companies hedge against warm winters. The
opposite is true for electric utilities. Cool summers reduce the demand for air conditioning which
lessens the volume of electricity sold.
Weather can seriously delay the progress of a construction project. Weather derivatives written
into a construction contract can hedge the risks and offset losses associated with adverse
weather.
Weather Insurance vs Derivatives

There are no great differences between the underwriting of a weather derivative and the more
traditional weather insurance contract. Weather derivatives cover low-risk, high-probability
events. Weather insurance, on the other hand, typically covers high-risk, low-probability events,
as defined in a highly tailored, or customized policy.
But there are differences with adjusting a claim. Payouts from derivatives are based on
objective data (temperature and precipitation records), not an assessed, measurable loss, which
can bring disagreements and delay. With a payout from a derivative, the company with the
contract can still profit. There is no moral hazard associated with a derivative, as no one can
manipulate the weather.
Buying a weather derivative begins with a company or organization calculating an index that

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Derivatives For All Seasons

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correlates the product it sells with how the weather affects it. The company brings its risk to us
and we tailor an index to address their risk, explains Brian OHearne, managing director of
Swiss Res environment and commodity market unit. If we agree with the statistics after
reviewing them, then we will offer a price for the derivative. If we dont have an appetite for a
particular risk, because we are not comfortable with the index, we will first work with the
company to revaluate the data and ask it to resubmit. Swiss Re is the largest writer of weather
derivatives in the world.
He advised companies wanting to buy a weather derivative to first and foremost know how the
weather affects their business, so that they can come up with an index that suits their needs.
They must think of the value of the program to them, balancing the price for the derivative
against the benefit.
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