Weather Derivatives

Weather derivatives are financial instruments that can be used by

organizations or individuals as part of a risk management strategy to reduce
risk associated with adverse or unexpected weather conditions. The
difference from other derivatives is that the underlying asset
(rain/temperature/snow) has no direct value to price the weather derivative.

The weather derivates market started in 1997 in the US as the first

transaction in this regard was recorded there but now this weather
derivatives market has spread to all major markets. According to US energy
market, US$ 1 trillion of the US economy is affected by the weather risk. By
the year 2000 about US$ 3.5 billion worth of weather derivates were traded
in the US.

There are 4 major players in the weather derivates market :

• MARKET MAKERS

• BROKERS

• INSURANCE AND REINSURANCE COMPANIES.

• END USERS such as Gas and power marketers and utilities etc.

Derivative is a contract or a security whose value or payoff derives from

the price of an underlying asset. Derivatives help an investor to control the
risks of changes in the prices of the underlying asset. For eg. An exporter
who receives his payments in foreign currency is exposed to currency risk ie
the risk of home currency appreciating with respect to the foreign currency.
When Rupee started appreciating against the US Dollar the textile exporters
and IT companies faces heavy losses if they had not hedged their positions.
Weather Measures
Weather measures are considered underlying assets of the weather
derivatives, as the price of a futures contract is an asset for an option on a
commodity. The two most common weather measures are – Heating Degree
Days (HDD) or Cooling Degree Days (CDD) – depending on the specifics of
the contract. It is estimated that 98-99% of the weather derivatives are now
using these temperature parameters. Other measures are based on
precipitation, which can be measured by the amount of rain over a given
time period or on Snowfall, measured by the amount of snow (or sleet) over
a given time period.

HDD and CDD

These weather measures are used to measure the demands that arise
due to the departure of the average daily temperatures from a base level.

An HDD (or CDD) is the number of degrees the day’s average temperature is
above (or below) a base temperature. They are calculated as follows:

Daily HDD = Max (0, base temperature – daily average temperature)

Daily CDD = Max (0, daily average temperature – base temperature)

Where,

Base temperature is defined as, the pre-defined base temperature, and,

Daily average temperature is measured as the average between the daily

high and the daily low.

Weather Derivatives in India

We have seen the how popular the weather derivatives have been
U.S.A. there the major customers for weather derivatives have been utility
companies but by Chicago mercantile exchange’s own admission the real
potential will be tapped when farming related activities start using the
weather derivatives. Weather derivatives have been launched in India as
well. Here the major customers will be the farming community. We don’t see
a huge potential for the derivatives by utility companies as India is a power
shortage nation and we don’t see the chances of excess power due to cooler
summers or warmer winters. The reasons why we think the weather
derivatives will be success in India are:

● Farmers
● Agriculture credit off-take in ninth plan – Rs. 2,31,798 crores
(grew @ 20% pa); Target for X plan – Rs. 7,36,570 crores
● 90% crop losses on account of weather related risks
● Rural Economy is highly weather dependent
● Commodity Traders
● Weather related supply bottlenecks make dry-land commodities
very volatile
● Intraday volatility of Guar, chilly touches 10-15% (daily trading at
national exchanges touches Rs.1000 crore daily)
● Vegetable and fruit Mandis highly dependent on temperature
(Delhi Mandi trade alone touches Rs.1000 crore annually)
● Trader income dependent on weather vagaries
● Industries like agro-input companies, food processing industry,
companies, plantations, FMCG, Banks, Power sector etc.
● Not uncommon to find Agri-Input companies, whose sale dips by over
30-40% due to fluctuation in rainfall
What needs to be done to establish a market for weather
derivatives in India:

First thing that needs to be done is to create the much needed

cash/spot market in India. Then we need to create an active futures/options
trading market in India
Deepening the Primary market

● Technology development
● Resolving the key constraints
Developing the secondary market in randem.

● Launching the Indices for key regions.

● Commodity funds, Agri-funds, Rainfall speculators, International
trading funds.
● Push for regulations on participation by Banks and MFIs.
● Presence in both the OTC and exchange traded market.
● Developing the Hybrid market.

BIBLIOGRAPHY:
http://en.wikipedia.org/wiki/Weather_derivatives

http://www.indianmba.com/Faculty_Column/FC1008/fc1008.html

http://financial-
dictionary.thefreedictionary.com/Weather+Derivative

http://www.livemint.com/2009/08/02222554/Ask-Mint--Weather-
derivatives.html

http://www.speedwellweather.com/

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