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Lecture 8: Weather Derivatives

Derivatives in Corporate Finance
Alonso Peña
SDA Bocconi, Intermediazione Finanziaria e Assicurazioni
Copyright SDA Bocconi, protocollo xxxx

Contents
Part 1:
Introduction
Part 2:
Examples of Weather Derivatives
Part 3:
Modelling Weather Derivatives
Part 4:
Case Study: United Nations World
Food Programme
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protocollo xxxx .Copyright SDA Bocconi.

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Part 1: Introduction Copyright SDA Bocconi. protocollo xxxx .

2008. We have covered a lot of different types of risks. and also credit risk. protocollo xxxx 8 8 . In this lecture we introduce derivatives on one of the most interesting and important sources of risk: the weather.Introduction Weather Derivatives* Weather Risk The study of derivatives entails understanding risk. and stock prices. Essays in Derivatives: Risk-Transfer Tools and Topics Made Easy. commodity prices. Chance. the main ones being market risk arising from interest rates. exchange rates. Copyright SDA Bocconi 2007 Copyright SDA Bocconi. Essay 20. Wiley. *These selections are from: Don M. 2 edition.

Even a child's lemonade stand benefits from hot weather.Introduction Weather Derivatives Weather and Business It is not difficult to think of the types of businesses that benefit or are hurt by the weather. Imagine beer and soda companies benefiting from hot weather and companies that sell hot chocolate and cocoa benefiting from cold weather. protocollo xxxx 9 9 . Copyright SDA Bocconi 2007 Copyright SDA Bocconi.

the travel industry.Introduction Weather Derivatives Weather and Business Ski resorts. and clothing manufacturers are good examples of companies whose business is partially and in some cases primarily driven by the weather. protocollo xxxx 1010 . The derivatives industry has recognized the importance of weather by creating a class of products known as weather derivatives. On a larger scale. vacation properties. Copyright SDA Bocconi 2007 Copyright SDA Bocconi. public utilities and airlines are heavily influenced by the weather.

Introduction Weather Derivatives Weather data Weather is an excellent variable on which risk can be measured. Statistical information is abundant. Copyright SDA Bocconi 2007 Copyright SDA Bocconi. Weather is typically a highly quantifiable variable. In fact. and virtually every adult and many children have a modest understanding of it. protocollo xxxx 1111 . we are inundated with information on weather. and lengthy series of historical data exist on temperatures and precipitation for localities all over the world.

com it is a relatively simple task to obtain qualitative and quantitative information on weather anywhere on the planet.yahoo. which have provided policies against weather-related damage for a long time. Copyright SDA Bocconi 2007 Copyright SDA Bocconi. Insurance companies.weather.com weather. protocollo xxxx 1212 . have extensive information about the historical consequences of severe weather.Introduction Weather Derivatives Weather data Internert sites: www.

Introduction Weather Derivatives Weather data: temperature The derivatives industry uses temperature as the underlying of various contracts by means of two related concepts: the heating degree-day (HDD) and the cooling degree-day (CDD). A cooling-degree day is the number of degrees the average temperature in a given day is above 65. Copyright SDA Bocconi 2007 Copyright SDA Bocconi. A heating degree-day is the number of degrees the average temperature in a given day is below 65 degrees Fahrenheit (18.33 Celsius). protocollo xxxx 1313 .

A heating-degree day is. If the average temperature in a day is 67 degrees. thus. the measure is two cooling degree-days. the weather is measured as two heating degreedays. Copyright SDA Bocconi 2007 Copyright SDA Bocconi. protocollo xxxx 1414 . while a cooling degree-day is a rough proxy for the necessity to provide coolness to obtain a comfortable temperature.Introduction Weather Derivatives If the average temperature in a day is 63 degrees. a rough proxy for the necessity to provide heat to obtain a comfortable temperature.

which is 7 cooling degree-days on average. Consider one six-month call option on cooling degree-days.Introduction Weather Derivatives The notion of a heating or cooling degree-day provides a reasonable underlying for weather derivative contracts. 30 x 7 = 210. Let us say the buyer expects that the average temperature over the next month (assume 30 days) will be 72 degrees. the buyer chooses 210 i. Then as a rough choice for the exercise price. protocollo xxxx 1515 .e. Copyright SDA Bocconi 2007 Copyright SDA Bocconi.

Introduction Weather Derivatives The buyer pays the premium and receives a call option that will pay at expiration a certain amount of money. call it m. protocollo xxxx 1616 . If the buyer is interested in benefiting from lower-thanexpected temperatures. Copyright SDA Bocconi 2007 Copyright SDA Bocconi. she would buy a put on heating degree-days and benefit if the number of heating degree days is lower than the chosen strike. the option expires out-of-the-money. for every cooling degree-day over 210. If the total number of cooling degree-days is less than 210.

determining m is the really difficult part. the child with the lemonade stand probably knows to make a few more liters of lemonade on those hot days and a few less on cooler ones. These estimates. protocollo xxxx 1717 .Introduction Weather Derivatives Of course. however. The option buyer needs to know what financial loss she expects on her business for each degree above 65 is the average temperature. Copyright SDA Bocconi 2007 Copyright SDA Bocconi. should be fairly well understood by anyone in business. Indeed.

Introduction Weather Derivatives Other forms of weather derivatives have been created on such measures as rainfall and snowfall. such as weather experts. Dealers that make these markets typically have an expertise in these markets. Often this expertise is purchased by buying another company or by hiring personnel. protocollo xxxx 1818 . Copyright SDA Bocconi 2007 Copyright SDA Bocconi.

The CME has also offered futures and options on futures on an index of hurricane intensity. These futures and options on futures are based on average temperatures in 18 U. protocollo xxxx 1919 . and the number of days of snowfall. and 15 non-U. Copyright SDA Bocconi 2007 Copyright SDA Bocconi. the number of days of frost.Introduction Weather Derivatives While most weather derivatives contracts are over the counter.S. exchange-traded weather derivatives have existed since the first ones were launched in 1999 at the Chicago Mercantile Exchange (CME).S. cities.

A few years ago the Chicago Board of Trade offered derivatives on insurance claims arising from hurricanes and earthquakes. These contracts drew a great deal of acclaim and attention. in particular from academics keen on deriving pricing formulas. these contracts did not draw much actual trading volume.Introduction Weather Derivatives In spite of great efforts. Copyright SDA Bocconi 2007 Copyright SDA Bocconi. protocollo xxxx 2020 . the CME contracts have not garnered much volume. But after all was said and done. however.

Copyright SDA Bocconi 2007 Copyright SDA Bocconi. but they are completely out of the traditional box of derivative products and therein lie some problems. They certainly are innovative. protocollo xxxx 2121 . their innovative nature has in some sense been their bane. Weather derivatives may be innovative. I can agree only on the first point. Nonetheless. striking at the very heart of certain significant risks encountered by many businesses.Introduction Weather Derivatives While some tout the weather and environmental derivatives markets as innovative and successful.

Copyright SDA Bocconi 2007 Copyright SDA Bocconi. and a price is based on a discounting of the expected payoffs. protocollo xxxx 2222 .Introduction Weather Derivatives Pricing weather derivatives typically occurs in a much more challenging manner. Usually the underlying variable and its financial consequences are forecasted. Pricing methodologies are discussed later.

Part 2: Examples Copyright SDA Bocconi. protocollo xxxx .

It funded this potential liability by purchasing snowfall digital floors structured in each major market where the promotion was offered (44 cities).Examples Corporate users 1997: the first widely publicised deal in the US took place between Enron and Koch Energy. in September 1998. Bombardier would pay a US$1. the first European deal between Enron and Scottish Power was made. protocollo xxxx 2424 .000 rebate to customers if snowfall levels did not reach half that of the previous three years. 1999: Canadian snowmobile maker Bombardier entered into a snowfall contract with Enron. Copyright SDA Bocconi 2007 Copyright SDA Bocconi. referenced to the Milwaukee winter season.

and if there are too many such days where the temperature was below 18°C in June and 20°C in July. the pub would receive compensation if there are too few such days where the temperature was above 14°C in April and 18°C in May.000 per day that was too cold to drink outside. Payment was triggered by the number of cold Fridays and Saturdays during the April-July period. In particular. Copyright SDA Bocconi 2007 Copyright SDA Bocconi.Examples Corporate users 2001: London-based The White Swan pub entered into a temperature contract with SocGen. protocollo xxxx 2525 . White Swan estimated that it stood to lose in excess of £15.

the Sacramento Municipal Utility District (SMUD) entered a five-year contract with Aquila. To ease the pain of high-cost droughts. Sacramento was to get less of its electricity from hydroelectric dams and pay higher prices for power on the open market. protocollo xxxx 2626 .Examples Corporate users 2001: the city of Sacramento in California entered into a precipitation contract with Aquila Energy. During droughts. Copyright SDA Bocconi 2007 Copyright SDA Bocconi.

aimed at protecting revenues in case of an unusually humid winter. a manufacturer of sore throat lozenges. protocollo xxxx 2727 .Examples Corporate users 2001: Japan's Imaoka Corporation. was one of the first companies to purchase a weather derivative referenced to humidity. sales often drop during the country's hot summer months (the soaring humidity levels lessening incidences of dry raspy coughs among the Japanese population). For Imaoka. Copyright SDA Bocconi 2007 Copyright SDA Bocconi.

Examples Corporate users 2002: Gut Apeldor golf club in Hennstedt. Copyright SDA Bocconi 2007 Copyright SDA Bocconi. bought a precipitation derivative that covered it from the risk of heavy rain keeping golfers away (the weather in 2001 had been miserable in that respect). The managers of the club decided that they could put up with 50 rainy days from May to September. Germany. protocollo xxxx 2828 .

which owns a: chain of wine bars in the City of London.” Copyright SDA Bocconi 2007 Copyright SDA Bocconi. protocollo xxxx 2929 .Examples Corporate users 2004: Corney & Barrow (C&B). The deal was brokered by Speedwell Weather.the first such undertaking by a non-energy company in the UK. has closed a weather derivatives deal with US energy giant Enron . a division of the UKbased bond software company Speedwell Associates.

Part 3: Modelling Copyright SDA Bocconi. protocollo xxxx .

protocollo xxxx 3131 . may not be too willing to share with outsiders). It prevents participants from talking in the same language.Modelling Pricing weather derivatives The lack of a single universal pricing model is a major hurdle to the growth of the weather derivatives market. predictably. with each market maker essentially developing its own pricing methodologies (which they. Copyright SDA Bocconi 2007 Copyright SDA Bocconi.

the weather market needs a common reference. this could greatly improve market transparency and would most likely enhance the number of entrants. the equity and currency options markets in the last 30 years. Just as the Black-Scholes breakthrough has been a key driving factor of the explosive growth experienced by.Modelling Pricing weather derivatives If a generally recognized pricing model were developed. protocollo xxxx 3232 . Copyright SDA Bocconi 2007 Copyright SDA Bocconi. among others.

applying it to weather derivatives is hazardous because there is no underlying tradable asset.Modelling Pricing weather derivatives Why is it difficult to come up with a standard weatherderivatives pricing formula? Plainly stated. While Black-Scholes modeling may be the standard approach for options pricing in many other derivatives markets. because the Black-Scholes framework cannot be used in this context. protocollo xxxx 3333 . Copyright SDA Bocconi 2007 Copyright SDA Bocconi.

Modelling Pricing weather derivatives Another obstacle lies in the fact that the mathematics behind Black-Scholes cannot be applied to the weather market. Copyright SDA Bocconi 2007 Copyright SDA Bocconi. Black-Scholes assumes that the underlying follows a random walk without mean reversion where the volatility increases with time. at least in the short term. protocollo xxxx 3434 . In practice. weather shows mean-reverting tendencies (tendencies to go back to its historical levels) and is reasonably predictable. Black-Scholes can be modified to take into account meanreversion.

protocollo xxxx 3535 . makes use of past weather data to determine the fair value of the option. Copyright SDA Bocconi 2007 Copyright SDA Bocconi. This method is quite straightforward. needing only the collection of historical time series and calculating what would have been the payoff for a particular option on each past date. Historical analysis.Modelling Pricing weather derivatives In light of these modeling difficulties. The price of the option should then equal the average of all those payoffs. practitioners have opted for two more hands-on: historical analysis and simulation. or "burn analysis".

it makes a difference how far back in time we go to calculate the average historical payoff of the option. 10-years data will most likely yield very different results from using 50-years data. depending on the time series considered. Copyright SDA Bocconi 2007 Copyright SDA Bocconi. say.Modelling Pricing weather derivatives A drawback associated with burn analysis is that it is totally data-dependent. A recent study of New York City's weather derivatives market found the following diverging figures for CDD. that is. (three winter months). (three summer months) and heating HDD. protocollo xxxx 3636 . Using.

protocollo xxxx 3737 . a large number of simulated random future weather scenarios to determine possible option payoffs. The option premium would then be the discounted average of all those possible payoffs. with the help of a computer. Copyright SDA Bocconi 2007 Copyright SDA Bocconi.Modelling Pricing weather derivatives Monte Carlo simulation seems to be the most commonly used method for pricing weather derivatives. It entails generating.

wind speed. Temperature is mean reverting and not a random walk (volatility stays within a reasonable range through time) Probabilistic process used for simulation purposes should take those aspects into account. Copyright SDA Bocconi 2007 Copyright SDA Bocconi. of course. rainfall.Modelling Pricing weather derivatives The drawback associated with simulation is. how to generate the future scenarios in the first place. protocollo xxxx 3838 . The answer lies in choosing an appropriate process for the underlying (temperature changes beyond an index. etc).

protocollo xxxx .Part 4: Case Study Copyright SDA Bocconi.

org/node/5 Copyright SDA Bocconi 2007 Copyright SDA Bocconi.Case Study UN World Food Programme Source: http://www. protocollo xxxx 4040 .wfp.

protocollo xxxx 4141 . Copyright SDA Bocconi 2007 Copyright SDA Bocconi.Case Study UN World Food Programme ADDIS ABABA – The United Nations World Food Programme announced today that AXA RE has been awarded the world ‟ s first insurance contract for humanitarian emergencies. The contract provides US $7 million in contingency funding in a pilot scheme to provide coverage in the case of an extreme drought during Ethiopia ‟ s 2006 agricultural season.

AXA is happy to provide its financial Copyright SDA Bocconi 2007 Copyright SDA Bocconi. offer us a way of insuring against these massive losses before they spell destitution for millions of families. “ As a worldwide leader in Financial Protection and one of the pioneers of weather cover through its subsidiary AXA RE. in the future.Case Study UN World Food Programme “The humanitarian emergency insurance contract might.” said Morris. protocollo xxxx 4242 .

we are testing whether it is possible to insure against the devastation caused by extreme drought. developed together with the World Bank Commodity Risk Management Group.Case Study UN World Food Programme “This contract heralds the beginning of what may be an entirely new way of financing natural disaster aid.” Copyright SDA Bocconi 2007 Copyright SDA Bocconi.” said Richard Wilcox. protocollo xxxx 4343 . Director of Business Planning at the World Food Programme . “ With this pilot.

the model has been designed on the basis of the potential losses that 17 million poor Ethiopian farmers risk should an extreme drought arise. protocollo xxxx 4444 .Case Study UN World Food Programme … the likelihood of widespread crop failure. While the experimental pilot transaction only provides a small amount of contingency funding. The policy complements recent UN Copyright SDA Bocconi 2007 Copyright SDA Bocconi.

however. so we will continue to need untied contingency funds. can also be managed effectively under the type of contract we have just signed with AXA Re . protocollo xxxx 4545 . Transferring weather risks from poor countries like Ethiopia into the Copyright SDA Bocconi 2007 Copyright SDA Bocconi.Case Study UN World Food Programme “Some disasters – especially conflict and displacement – are harder to predict and faster to unfold. Risks such as drought.” explained Wilcox.

” said Robert Shiller.Case Study UN World Food Programme “ The portfolio effect of bringing emergency aid into the international risk markets is a win. Professor of Financial Economics at Yale University and author of „ The New Financial Order: Risk in the 21st Copyright SDA Bocconi 2007 Copyright SDA Bocconi. Wit h this deal WFP is making a bold move towards more equitable and effective international risk management . protocollo xxxx 4646 .win for developed and developing countries.

Case Study UN World Food Programme “We have shown that the reinsurance sector can have an important role to play in effective financing for responses to natural disasters in developing countries. protocollo xxxx 4747 . Copyright SDA Bocconi 2007 Copyright SDA Bocconi. Now the industry itself should take up the challenge to provide effective products to developing countries and the aid community.

including 61 million hungry children. WFP -. protocollo xxxx 4848 .Case Study UN World Food Programme References: WFP is the world's largest humanitarian agency: each year. in at least 80 of the world's poorest countries.We Feed People. we give food to an average of 90 million poor people to meet their nutritional needs. Copyright SDA Bocconi 2007 Copyright SDA Bocconi.