RISK MANAGEMENT

Lecture 15

Credit, Weather, Energy, and Insurance

Derivatives
&
Derivative Mishaps
Credit, Weather, Energy, and
Insurance Derivatives
 These products have been developed to
manage weather risk, energy price risk and
risks facing insurance companies.
 The markets are still evolving.
Credit Derivatives
 Total Return Swap.
 In this return from one asset or a group of asset is
swapped for return on another.
 Credit Spread Options.
 It is an option on the spread between the yields
earned on two assets.
 The option provides a pay-off whenever the
spread exceeds some level.
Credit Derivatives
 It is a contract in which the pay-off depends on
credit-worthiness of an entity.
 Most popular is Credit Default Swap.
 The buyer obtains the right to sell a particular bond
issued by a company for its par value when a
default happens.
 The buyer makes periodical payments to the seller.
 If a default happens the settlement may be in cash
or by physical delivery.
Weather Derivatives
 Performance of many companies is liable to be
adversely affected by weather.
 Weather Derivatives are used to hedge weather
risks.
 Initially developed in OTC market, now also available as
exchange traded instruments.
 These are priced using historical data.
 A typical contract provides a payoff dependent on
cumulative HDD or CDD during a period.
 Weather derivatives are often used by energy
companies to hedge the volume of energy required
for heating or cooling during a particular month.
Weather Derivatives: Definitions
 Heating Degree Days (HDD): For each day
this is max(0, 65 – A) where A is the average
of the highest and lowest temperature in ºF.
 Cooling Degree Days (CDD): For each day
this is max(0, A – 65).
Weather Derivatives: Options
 A typical OTC Call Option: On cumulative
HDD in December 2006 at the Chicago
weather station with a strike of 700 and a
payment rate of $10,000 per degree day.
 These contracts often include payment cap,
say, $1.5 million in above case.
 This is equivalent to a bull spread with long
call of strike 700 and short call of strike 850.
Energy Derivatives
Main energy sources:
 Crude Oil

 Gas

 Electricity
Crude Oil Derivatives
 Virtually all derivatives available on stocks and stock
indices are also available in the OTC market with oil
as the underlying asset.
 Futures and futures options traded on the New York
Mercantile Exchange (NYMEX) and the International
Petroleum Exchange (IPE) are also popular.
 Some exchanges have cash settlement while others
have physical delivery.
Natural Gas Derivatives
 A typical OTC contract is for the delivery of a
specified amount of natural gas at a roughly
uniform rate to specified location during a
month.
 NYMEX and IPE trade contracts that require
delivery of 10,000 million British thermal units
of natural gas to a specified location.
Electricity Derivatives
 Electricity is an unusual commodity in that it
cannot be stored.
 The U.S is divided into about 140 control
areas and a market for electricity is created
by trading between control areas.
Electricity Derivatives
 A typical contract allows one side to receive
a specified number of megawatt hours for a
specified price at a specified location during
a particular month.
 Types of contracts:
 5x8, 5x16, 7x24.
 Daily or monthly exercise.
 Swing options.
How an Energy Producer
Hedges Risks
 An energy producer faces two types of risk:
 Price risk
 Volume risk
 Less than perfect relationship between the
two.
 Therefore both risks need to be hedged.
How an Energy Producer
Hedges Risks
 Estimate a relationship of the form
Y=a+bP+cT+
where Y is the monthly profit, P is the average
energy prices, T (HDD or CDD) is
temperature variable for the month and is
an error term.
 Take a position of –b in energy forwards and
–c in weather forwards.
Insurance Derivatives
 Traditionally, insurance companies have used
‘reinsurance’ to hedge against catastrophic risks.
 CAT bonds are an alternative to traditional
reinsurance.
 This is a bond issued by a subsidiary of an
insurance company that pays a higher-than-normal
interest rate.
 If claims of a certain type are above a certain level
the interest and possibly the principal on the bond
are used to meet claims.
Derivative Mishaps
Derivative Mishaps
 Huge losses have been caused by activities
of certain individuals:
 Nick Leeson: Barings Bank.
 Robert Citron: Orange County.
 Joseph Jett: Kidder Peabody.
Lessons From Derivative
Mishaps
 Define risk limits.
 Take limits seriously.
 Do not turn blind eye to high profits if made by
exceeding risk limits.
 Do not assume you can outguess the market.
 Carry out scenario analysis.
Lessons For FIs
 Monitor traders carefully.
 Do not blindly trust models.
 Separation of front office & back office.
 Recognition of inception profits.
 Do not sell inappropriate products.
 Do not ignore liquidity risks.
 Be careful when everybody is following same
trading strategy.
Lessons For NFIs
 Make sure you understand trades carefully.
 Make sure a hedger does not become a
speculator.
 Be cautious about making Treasury Dept a
profit centre.