Weather Risk Management

David Molyneux, FCAS

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Introduction
Weather Risk - Revenue or profits that are sensitive to weather conditions

Weather Derivatives - Financial Products that

allow companies to manage or hedge their weather related risk exposures

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Weather Derivative Basics

Like Financial derivatives, Weather derivatives are used to hedge risk The value of a Financial derivative depends on the

value of an underlying asset, index or commodity

The value of a Weather option depends on the value of an underlying weather statistic Weather Derivatives protect against abnormal weather outcomes
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Weather Derivative Customers

Utilities and energy companies Agricultural companies Municipalities

Seasonal Clothing Manufacturers

Ski/Beach Resort Operators Golf Course Management Companies Beverage Companies & Distributors
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Weather Derivative Risks

Average Temperature - HDDs/CDDs Abnormal Temperature - # of Days above 100F Precipitation or snowfall

Humidity
Wind speed Riverflow Combinations of the above
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Heating and Cooling Degree Days

Most temperature contracts in current practice are based on Heating Degree Days (HDD) for winter protection, and Cooling Degree Days (CDD) for summer protection. HDD = Max (0, 65 F - average temperature in a day) CDD = Max (0, average temperature in day - 65)
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How Weather Derivatives Work

Pay off is based on a measurable index (CDD,

HDD, etc)
Pay off is based on how the index performs relative to a trigger or strike value - not on actual loss Coverage usually has a defined maximum limit
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Basic Option Terminology

Weather Options pay off when the underlying weather statistic is above or below a certain strike value

Put Options - pay if the weather statistic is below

the predetermined strike value Call Options - pay if the weather statistic is above the predetermined strike value
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Option Payoffs
Call Payout
10 10

Put Payout

Strike -5 -5

Strike

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Simple Example - Snow Removal

Problem: The municipality of Fort Wayne, IN has spent

$3,000,000 to provide for snow removal for the upcoming winter.

This money will fund the equipment and labor to remove 12 inches of snow. Because of overtime rules, the municipality

estimates that every additional1/2 inch of snow leads to an

additional $250,000 of snow removal costs. Solution: A Snowfall call option which pays $250,000 per 1/2 inch of snowfall above a strike of 12 inches to a maximum of 20 inches.
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Snowfall Call Option

Call Option Features
5.0
Removal Cost (Millions)

4.5 4.0 3.5 3.0 2.5

Unhedged Costs

Period = Nov-Mar Strike = 12 inches Limit = 20 inches Tick= $250,000

Hedged Costs

Limit = $4,000,000
Price = $500,000
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12 Inches of Snow

15

18

Snowfall Distribution
Snowfall Probability Distribution
16% 14% 12% 10% 8% 6% 4% 2% 0% 6 7

Below the Strike

Above the Strike

10

11

12

13

14

15

16

17

18

Inches of Snow

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Removal Costs With & Without the Call

Probability 4.0% 5.0% 7.0% 9.0% 10.0% 12.0% 15.0% 12.0% 10.0% 8.0% 4.0% 3.0% 1.0% Average
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Inches of Snow 6 7 8 9 10 11 12 13 14 15 16 17 18 12

With Call 3,500,000 3,500,000 3,500,000 3,500,000 3,500,000 3,500,000 3,500,000 3,500,000 3,500,000 3,500,000 3,500,000 3,500,000 3,500,000 3,500,000

Without Call 3,000,000 3,000,000 3,000,000 3,000,000 3,000,000 3,000,000 3,000,000 3,500,000 4,000,000 4,500,000 5,000,000 5,500,000 6,000,000 3,465,000

Effect of the Call Purchase

If the total snowfall exceeds 12 inches - the payoff from the call exactly offsets the increased cost of snow removal

Fort Wayne guarantees snow removal costs of

$3.5 mil Variability is reduced - although Expected Cost is actually higher
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Pricing Weather Derivatives

Method 1 - Apply Structure to Empirical Data
NCDC Historical Database
Adjust the Historical Data Apply Derivative Structure to Adjusted Data

Method 2 - Simulation
Fit a Probability Distribution to Adjusted Data Model Stochastically

Black Scholes does not work!!!

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Data Adjustments
Station Changes
Instrumentation
Location

Trends
Global Climate Cycles
Urban Heat Island Effect

ENSO Cycles

Forecasting

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Phoenix CDD Data

Phoenix CDD Data Jun-Sept
3600 3400 3200 3000 2800 2600 2400 2200

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19 49 19 53 19 57 19 61 19 65 19 69 19 73 19 77 19 81 19 85 19 89 19 93 19 97

Phoenix CDD Data - Adjusted

Phoenix CDD Data Adjusted for Trend
3800 3600 3400 3200 3000 2800 2600 2400 2200

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19 49 19 52 19 55 19 58 19 61 19 64 19 67 19 70 19 73 19 76 19 79 19 82 19 85 19 88 19 91 19 94 19 97
Original Adjusted

Phoenix CDD Call Graph

3600 3400 3200 3000 2800 2600 2400 2200

1949

1953

1957

1961

1965

1969

1973

1977

1981

1985

1989

1993

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1997

Phoenix CDD Call - Impact of Data Adjustments

CDD Call Structure
Period = Jun-Sept Strike = 3,200 Tick = $10,000 Limit = $2 mil Based on Adjusted Data:

All Year Expected Loss

Based on Unadjusted Data:

$826,000

$1.3 mil

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Simulation Analysis
Fit a Distribution to Adjusted Data
Normal & Lognormal often work for HDD/CDD Other Statistical Models can be used for Percip, etc.

Fit can be focused on area between strike and limit Run simulation analysis

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Portfolio Management
Diversify Geographically & Directionally Track Correlations Between Cities Manage Transactional & Aggregate Limits

Hedging & Trading Strategies

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Future of the Weather Market

Growth in the Overall Size of the Market Larger/Multi-Year/More Complex Deals International Expansion

Expanded End User Market

Imbedding Weather Derivatives in Insurance or Other Types of Contracts

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