Hedging Weather Risk: Weather Derivatives

Since market’s background, rationale, structure and growth have already been argued, this chapter is dedicated to weather risk management products analysis. In particular, the discussion is centred on climatic non-catastrophic risk management. This particular type of weather risk is usually hedged by using weather derivatives.

Basically, a weather derivative is a financial derivative whose underlying asset is a weather index measured by a reference weather station. Thus, as a stock option’s value is based on the price at which the reference company stocks are traded, a weather option depends on the climatic trends of the underlying entity (e.g. rain, snow, temperature etc…).

Weather derivatives occupy only a tiny share of the entire financial derivatives market and are usually listed as exotic financial instruments. They are named “exotic” because of their unconventional features: they are built on weather indexes. Conversely, classical derivatives, because of their relative simplicity, are known as “vanilla”. Although the products range is continuously increasing because of liquidity injections and market awareness, weather certificates show some common features. Every weather derivative presents some distinctive characteristics.

Reference Weather Station (Location) Every contract must enclose a reference weather station. This is due to the fact that the counterparties do not only need to comply with the same location, but they must also agree on a precise station. Weather phenomena are extremely local events: a rainfall may occur different times and in different places within the same region. For these reasons, deciding the reference weather station consists of relying upon its atmospheric data. This entails a consistency issue. In fact, the more the business activity is related to the precise weather station’s climatic data, the easier and the cheaper to hedge against weather risk. As a consequence of this, many companies, operating in extended regions, agree on multiple weather stations. By doing this, they can pool respective weather data (e.g. taking the average) and obtain more consistent results.

Index As it has been pointed out many times, weather certificates must be based on a weather index. Clearly the choice of the index depends on the weather-sensitivity the company has. For instance, if there is a significant indirect relationship between warmer winters and gloves’ seasonal sales, the retailers should look for the indexes that better express this connection. Since the retailer knows that the colder the winter, the higher its profits, it should arrange the contract such that it is repaid in case the average winter temperature will be higher than its optimal level. In order to know its right level, the retailing company should regress its winter sales records on winter average temperatures. Basically, an index is every possible combination of weather data. Nevertheless, because of market conventions and structure, especially in public markets some common indexes may be found. The most used and traditional indexes are the Cooling Degree Days (CDDs) and the Heating Degree Days (HDDs). However, as the market expansion proceeds, many other hybrids appear. These combinations may also include precipitation and temperature measures in the same index and they are usually tailored on sectorial peculiarities.

Term. Contracts have a starting and an ending date. Normally, weather derivatives may be weekly, monthly or seasonal. Even though weekly contracts are still rather rare, monthly and seasonal products are easily findable. Indeed, as of today the Chicago Mercantile Exchange (CME) offers weekly certificates only for U.S. locations and only based on temperatures. Conversely, monthly and seasonal weather derivatives are available in all listed cities and for all weather phenomena (e.g. temperature, rainfall, frost, and snowfall). Summer weather certificates usually range from May to September, while winter products ordinarily start in November and end in March. Nonetheless, there are no limits or fixed conventions. Thus it is not rare to find weather certificates covering shorter or longer periods. In order to address single purchaser needs, some contracts specify whether to include or not include weekdays or weekend days. Recent market developments show an augmented interest towards seasonal products.

Structure and Payoff Function. As every other financial derivative, a weather derivative is characterized by a payoff function: payments due to its owner depending on the underlying entity behaviour. Referencing to this function characteristics, weather certificates may be structured as calls, puts, collars, swaps, strangles, straddles or spreads38. These products are structured such that for a specific index movement, there is always a payout response. Their variety offers the possibility to address many weather risk situations.

Strike. The strike is the trigger level of the reference index at which the contract owner starts to receive payments. For instance, if an electric utility is concerned with experiencing a cold July, it may decide to be paid for every day colder than 20°C. The 20°C, in weather derivatives jargon, is the strike level. The more complicated the certificates, the higher the possibility they contains more than a strike level. In these cases, these points may be called lower/upper attachments depending on their mutual position.