Weather derivative

A weather derivative is a derivative financial instrument used in the meteorological data such as temperature or rainfall as an underlying. Weather derivatives are usually between a bank or insurance company and a contractor ( company, municipality ), the company transferred its weather risk to the bank. Since, according to estimates by economists about four-fifths of all economic activities are directly or indirectly affected by weather worldwide, weather derivatives can be a tool of risk management of a company. However, the developed only towards the end of the 1990s, weather derivatives are still a relatively young instrument in the financial market that are not standardized, unlike other hedging instruments, for example, interest rate or exchange rate risks. Weather futures as a standardized product can be traded so far in only a very small extent on Eurex, the Chicago Mercantile Exchange and the Liffe in London.

• 3.1 entrepreneur
• 3.2 Banks
• 3.3 individuals as beneficiaries of weather derivatives?

Example of a risk transfer by a weather derivative

With the following - designed - as the operation and applications of weather derivatives can be easily explained:

A farmer who grows peaches in Central Europe is reliant on the temperature never drops below a certain temperature during the heyday of the frost-sensitive trees. The longer the temperature is below 5 ° C, the lower its harvest. His business management risk can be transferred to a bank of these farmers by entering into a corresponding weather derivative with the seller. The contract could be designed so that the farmer for every day of the months of April and May - so the months, which bloom in the frost-sensitive peach trees - where the temperature measured by the nearest weather station temperature falls below 5 ° C, a balance amount of 1,000 euro gets. Whether he pays an option premium for this contract, or if he has a payment obligation to the bank, when the temperature is about five degrees Celsius, depending upon which specific hedging instrument is chosen.

The hedging instruments

Peculiarity of weather derivatives in comparison to other derivative financial products

The instruments used are used in weather derivatives are similar in their construction is essentially the usual derivative hedging instruments that are used in financial management. However, weather derivatives have a special feature: the objects to which they refer (referred to in the art as underlyings ), namely daytime temperatures, snow depth, precipitation, or the like, are not tradable. This has some consequences in corporate practice and in financial mathematics dealing with this instrument. The volatility of weather derivatives is derived solely from the historical weather data. There is no market price volatility in the classical sense, as it is the case for hedging instruments for equities or currencies. Unlike stocks or commodities such as silver of the underlying is not influenced by individual market participants by large amounts sold by this example, at certain times or speculate market participants to price increases. The base value of weather derivatives can therefore be considered to be free of market manipulation.

Unlike other derivative hedging instruments when weather derivative for physical delivery at maturity is excluded. Would the farmer who grows peaches, its anticipated autumnal harvest sale in the spring to date, he could actually deliver his opponent the agreed amount on the due date of its fixed-price transaction also. Such contracts - like the actually completed in Chicago in commodity futures markets - are, however, generally offset by compensation. In this so-called weather derivatives cash settlement, however, is the only way to exit the business.

As continues to be problematic pricing applies to the weather derivatives. The Black-Scholes model, which is otherwise used as a standard for pricing, does not fit for this instrument. A Monte Carlo simulation, which can be used alternatively, is very complex in its application. While banks this is usually because of their software facilities can still reproduce, this is particularly a problem for companies that need to be in a position due to corporate rules, to evaluate completed financial derivatives independently. Degrees in weather derivatives would therefore be accompanied at these companies with an elaborate upgrade their treasury systems.

Underlying weather derivatives

Weather derivatives can reference a very large number of different underlying assets, as there are a variety of ways to quantify weather. In order to hedge commercial risks in the appropriate weather derivative must, however, relate to the correct underlying to represent a useful hedge. In the above example of the peaches -growing farmer the average daily temperature in Germany or Austria is irrelevant - for him rather plays a role which temperature is measured near his peach orchard. For a municipality that wants to hedge against high snow removal costs, would be analogous not the snowfall on the Zugspitze decisive, but on-site measured.

Temperature is used as Wettermaß most. After an investigation of the Weather Risk Management Association had all completed in 2002 by weather derivatives 95 % Temperature values ​​as underlying. Other basic values ​​are the wind speed, snow and rain, water level, cloud cover, sunshine duration or the relative humidity. For snow and rain i.d.R. once per day, measured in the last 24 hours rainfall in millimeters measured.

The exemplary farmer who wants to hedge the temperature dependence of its peach crop, it will be hard to find a weather station that is located in such close proximity to his plantation that it reproduces the essential for him right temperature. However, it is possible to combine the values ​​of several weather stations so that the probability that this is relevant for him temperature is specified for it. Other companies with a different risk profile than the exemplary farmer conclude long -term contracts, as this provides a better guarantee that they will receive a payout from the closed weather derivative, which corresponds to their level of business risk.

Hedging instruments

In the terminology, structure and management practice, weather derivatives correspond to the usual financial derivatives. Options and futures are the usual forms of transactions, which are used here. Particularly options are typical instruments, which account for about 70 to 80% of the financial statements according to estimates by market participants. As with the hedge exchange rate and interest rate risks, a number of option structures are conceivable, which can be configured in a very differentiated according to the risk profile.

Futures

A forward contract - often referred to in this context in the jargon as swap - is the easiest traceable instrument in the weather derivatives. A premium payment is omitted here; Instead, exchange bank and companies weather risks. For the peaches -growing farmer, this would mean an agreement with his bank, where he will receive a payout of € 1,000 for each day on which the temperature falls between April and May below five degrees Celsius. Conversely, it must in this type of transaction, the farmer for each day on which the temperature is about five degrees Celsius, pay 1,000 euros to the bank. The maximum amount payable for both counterparties would in this contract construction at 61,000 euros. Before signing this contract, however, the farmer must decide whether this construction at all corresponds to its risk profile. For this analysis, including a preoccupation with the question of whether he really loses only 1,000 euros to harvest when the temperature in this period is striking, for example, -3 ° C and the total flowering of trees is destroyed in the process belongs. Conversely, he must wonder if with each day on which the temperature is about five degrees Celsius, it really an additional amount will have to harvest in the fall, which corresponds to 1,000 euros, which he then has to pay to the bank.

The example of a producer of ice cream, however, shows that a forward contract can be constructed so that it conforms to an established risk structure. Based on previous analyzes of this producer knows that with each additional degree Celsius, which is the average temperature during the months of June, July and August below 20 degrees, it loses a million euros and thus € 100,000 revenue gain. With each additional degrees Celsius at which the average temperature is above 25 degrees Celsius, it is, however, for a million Euro more ice. These fluctuations in the volume of sales he wants to compensate by making an appropriate forward contract. He concludes accordingly from a forward contract with its bank, which the associated with the sales slump in profit, which he suffered in an unusually cold summer compensated. The profit he would have in an unusually hot summer, he is willing to give up for it.

Options

Options are the most common form, are protected by the weather risks. It put options a bet on falling and purchase options a bet on rising indices mean. In any case it is necessary for the option to pay a premium. However, the option is to hedge the weather risk, while preserving the earnings potential of a company.

Both the ice cream maker as well as peach -growing farmers seek to protect their business risks, which are falling temperatures for them. Both would therefore buy a put option. The peach -growing farmer has decided that it is better suited to its risk structure when it receives a payment amount of 100 euros for each degree below a measured in April and May daily temperature of 5 degrees Celsius.

Call options are purchased in one of which, where weather indices represent increasing risk. Your application displays a closed in 2001 contract with one located in rural areas of Lower Saxony power station. Analysis of several years had shown in this undertaking, that in the summer months of the current sales to a part was dependent on how often farmers hired their irrigation systems. Very rainy summer could mean a slump in annual profits up to 20 percent for this company. Therefore, the company bought a call option whose payoff amount depended on rainfall dependent. The contract had a period from 1 May to 31 August 2001 as the base value, measured in millimeters rainfall located near a weather station. The so-called exercise price of the contract was 70 millimeters rainfall since analyzes showed that the average rainfall was 65 mm. This means that the company was willing to carry the profit decline, which was associated with rainfall 65-70 millimeters itself. Against the lost profits that went with higher precipitation totals associated, the company wanted to protect it. The company agreed for every millimeter larger than 70 millimeters of precipitation, therefore, a payment amount of DM 2,000 as an option premium, the company paid a little less than 10,000 DM was Contracted a maximum payout amount, such amount has remained unknown.

Market participants

Entrepreneur

Although in this article variously farmers and municipalities were tried as a counterparty to a weather derivative, these have, so far not the typical participants in the market for weather derivatives dar. pioneer in the market for weather derivatives were U.S. electric utilities, where the daily amount of energy consumption is strongly correlated with the current average daily temperature. However, the experience of these companies also show how complex is the risk-adequate design of a weather derivative. Energy consumption and daily temperature are not linearly correlated with each other, but it must be very differentiated distinction between such days that the energy consumption increases because households heat, and those to which the production of energy is consumed because they turn on their air conditioners.

In addition to the utilities, it is primarily insurers and reinsurers, for weather derivatives as hedging instruments are interesting.

Generally, companies that are considering the use of weather derivatives or those who already completed, already had experiences with the use of derivative instruments to hedge financial risks. Therefore, they are familiar with the risk management process to which the first step involves careful analysis of their own risk structure. You also have the necessary management to the so-called front office, a processing ( back office ) and generally also a financial risk control counts.

Banks

Banks close on occasion, weather derivatives and therefore from because they actually want a weather risk they have due to their business secure. Their motivation then corresponds to the risikoabsichernden companies described herein.

In this article, they are described as the counterparty to which a company is transferred through the conclusion of a weather derivative 's risk, and that is usually the reason enter into such a contract from the financial institutions. They thus fulfill its classical function in the economy of the risk, time limits and lot sizes transformation. Banks can offer their customers such products are usually very active and large participants in the financial markets. A small savings bank or a small VR-Bank, the abschlösse into such a contract with their customers, would pass on this deal at such a bank. In practice, however, such small banks may rarely occur as a counterparty of weather derivatives, as even the passing of such contract makes business processes required over which such Bank does not have. But the question of the accounting treatment of such derivative may make it unattractive for a savings bank or VR-Bank to conclude such an instrument.

Banks, the weather risks " take on their books ," thus reducing their risk taken by a variety of contrasting possible futures and secure the remaining risk from by a very active trading on the stock exchanges on which weather derivatives are traded standardized. This action will take place as long as the relevant stock exchanges are open. During the trading hours of the LIFFE would accordingly observe the so-called weather risk this book and then pass it on to the Chicago colleagues, so that they manage this during the trading hours of CME the London or Frankfurt office of a bank.

Individuals as beneficiaries of weather derivatives?

Weather derivatives are usually not any products that are completed by individuals. However, in individual tourism companies offer their package travelers occasionally a "money back guarantee " if the number of rainy days in the holiday country is above a specified number. Such offers are usually laced by the company for marketing reasons. The weather risk, thus additionally received a travel provider, he usually wears not himself, but also ensures it off by the conclusion of weather derivatives. In this way may be profiteer of weather derivatives and the end user.

Private individuals who own shares and therefore are shareholders of a company may be indirectly affected by weather derivatives. Do they have as a shareholder interest in a permanent dividend equal as possible, they probably welcome the conclusion of such contracts, as these can contribute significantly to the stabilization of corporate profits if used correctly. Those who consciously shares different weather-dependent businesses combine to diversify their portfolio, on the other hand have no interest in that only some of the companies in which they are involved, to hedge its exposure via derivatives, as would be contrary to their own diversification strategy. However, shareholders have an interest in ensuring that an appropriate risk management process has been established in each case. Both major shareholders as well as the users of the small shareholder representatives therefore scrutinize such statements and analyzes on which is based their conclusion, critical. The same applies to employee representatives, where workers rather among the profiteers properly inserted, weather derivatives, as companies with stable profits rather a secure job offer as such, varies greatly their corporate profits due to exogenous factors.

Development of the market

First time in 1997, a weather derivative between two counterparties was completed. In September 1999, the Chicago Mercantile Exchange introduced weather derivatives and European options on futures weather as a standardized exchange product. Were offered contracts that could be used as underlyings have the average monthly temperature values ​​measured by weather stations in Atlanta, Chicago, Cincinnati, Dallas, Des Moines, Las Vegas, New York, Philadelphia, Portland or Tucson.

The development of weather derivatives in the late 1990s was much influenced by the hope that you would see here a rapidly growing market: A variety of businesses are dependent on the weather, and since the 1980s, the use of derivative instruments to hedge interest rate - and increased exchange rate risks greatly, leaving many companies with the use of these instruments - the basic principles also apply to weather derivatives - are familiar. The expected growth - still estimated at double-digit annual growth rates in early 2003 - has so far not occurred. Some well-known and large banks that normally belong to the providers of innovative financial products, have now stopped selling these derivatives back even.

This surprising for many market participants development is due to the complexity of hedging with weather derivatives. Although neither the weather dependence of many business activities is the possibility of companies to hedge their risks may also, without controversy. As the above examples, however, businesses must first conduct a very thorough risk analysis to define weather derivatives so that they reflect the risk profile. Incorrectly completed derivatives carry instead of a hedge may contribute to increase the business risk. Banks must be reversed in a position to assess such individually tailored contracts in order to adequately monitor the risks they take with the launch of such a contract can. Such weather- based contracts can therefore be associated with a high cost for both parties, which means that to be the trading volume is not very large.