Weather Derivatives

Dr Harvey Stern,
Victorian Regional Office
Weather Services Planning Conference
Friday 19 April 10.15am-10.45am
 The Noah Rule

“Predicting rain doesn’t count;

Building arks does”.

Warren Buffett,
Australian Financial Review,11 March 2002.
 Outline of Presentation

• Some recent developments in weather risk.

• Applications of weather derivatives.
• Utilising forecast accuracy and other databases.
• Role of ensemble weather forecasting.
• Recommendations to enable the BoM to keep abreast of
devlopments in this growing sector of weather services.
 Introduction

• The meteorological community is becoming increasingly skilled

at applying weather-related risk management products.
• Most of these products originate from the financial markets.
• It is the energy sector (in the USA) that has, so far, taken best
advantage of the growing weather-risk market.
 The words of O. G. Sutton
“The analogy between meteorology and astronomy is often made
… There is a closer resemblance, to my mind, between
meteorology and economics. Both deals fundamentally with the
problem of energy transformations and distribution
- in economics, the transformation of labour into goods and their
subsequent exchange and distribution;
- in meteorology, transformation and distribution of the energy
received from the sun. Both are subject to extremely capricious
external influences.”

(from “Mathematics and the future of meteorology”, Weather, October, 1951)

 Background

• The property and casualty reinsurance industry experienced

several major events during the late 1980s & early 1990s.
• The ensuing industry restructuring saw the creation of new risk-
management tools.
• These tools included securitisation of insurance risks.
• A third party issues these securities.
• The securities provide a return structured in a manner related to
the occurrence (or otherwise) of an adverse event.
 Weather Risk

• Weather risk is one of the biggest uncertainties facing Australian

business.
- We get droughts, floods, fire, and cyclones.
• Economic adversity is not restricted to disaster conditions.
- A mild winter ruins a ski season, dry weather reduces crop
yields, & rain shuts-down entertainment & construction.
- Recently, a brewer blamed an earnings decrease on a cool
summer.
 Securitisation of Weather Risk

• Weather securitisation may be defined as the conversion of the

abstract concept of weather risk into packages of securities.
• These may then be sold as income-yielding structured
products.
 Forecasts

• Weather forecasts may be used to manage risk associated with

short-term activities (e.g. pouring concrete).
• Climate forecasts may be used to manage risk associated with
long-term activities (e.g. sowing crops).
• With the focus upon managing risk, the forecasts are
increasingly being couched in probabilistic terms.
 The Road to
Weather Risk Management.

• The era of (mostly) categorical forecasts.

• The rapid increase in the application of probability forecasts.
• The provision of forecast verification data.
• The era of the “guaranteed forecast”, with user communities
being compensated for an inaccurate prediction.
• The purchase of “stakes” in the industry (by multi-national
companies).
 Australian Developments
• For many years, the power industry has received detailed
weather forecasts from the Bureau.
• Now, Australia has joined the global trend towards an increased
focus on the management of weather-related risk.
• The first instance of an (Australian) weather derivative trade
occurred about two years ago.
• A number of businesses have now moved into the trading of
weather risk products, almost all “over the counter”.
• Partnerships between merchant banks and weather forecasting
companies.
Weather-risk & the Financial Markets
• Weather-linked securities have prices which are linked to the
historical weather in a region.
• They provide returns related to weather observed in the region
subsequent to their purchase.
• They therefore may be used to help firms hedge against weather
related risk.
• They also may be used to help speculators monetise their view of
likely weather patterns.
 Should Companies Worry?

• In the good years, companies make big profits.

• In the bad years, companies make losses.
- Doesn’t it all balance out?
- No. it doesn’t.
• Companies whose earnings fluctuate wildly receive
unsympathetic hearings from banks and potential investors.
 What is a Derivative?

A Derivative is a financial instrument

whose value is derived from
the value of some other financial variable.
 A Familiar Example
of a Derivative.

A familiar example of Derivatives were the

TELSTRA Instalment Receipts.

Their value fluctuated in accordance with

fluctuations in the value of TELSTRA shares.
What is a Weather Derivative?

A Weather Derivative is a financial instrument

whose value is derived from the
magnitude of some weather variable.
 Expanding the Definition

• Weather derivatives are financial instruments that are utilised

to manage weather (& climate) related risk.
• They are similar to conventional financial derivatives.
• The basic difference lies in the underlying variables that
determine the pay-offs.
• These underlying variables include temperature, precipitation,
wind, and heating (& cooling) degree days.
 Derivative or Insurance?

A Derivative:
-has ongoing economic value,
-is treated like any other commodity,
-is accounted for daily, &
-may therefore affect a company’s credit rating.
An Insurance Contract:
-is not regarded as having economic value, &
-therefore does not affect a company’s credit rating.
 Some Important Issues

• Quality of weather and climate data.

• Changes in the characteristics of observation sites.
• Security of data collection processes.
• Privatisation of weather forecasting services.
• Value of data.
• Climate change.
 An Early Example

• In 1992, the present author explored a methodology to assess

the risk of climate change.
• Option pricing theory was used to value instruments that might
apply to temperature fluctuations and long-term trends.
• The methodology provided a tool to cost the risk faced (both
risk on a global scale, and risk on a company specific scale).
• Such securities could be used to help firms hedge against risk
related to climate change.
 Another Example
• A common example is the Cooling Degree Day (CDD) Call
Option.
• Total CDDs in a season is defined as the accumulated number
of degrees the daily mean temperature is above a base figure.
• This is a measure of the requirement for cooling.
• If accumulated CDDs exceed “the strike”, then the seller pays
the buyer a certain amount for each CDD above “the strike”.
 Specifying the CDD Call Option
• Strike: 400 CDDs.
• Notional: $100 per CDD (> 400 CDDs).
• If, at expiry, the accumulated CDDs > 400, the seller of the
option pays the buyer $100 for each CDD > 400.
Pay-off Chart for the CDD
Call Option
 Approaches to Pricing

• Historical simulation.
• Direct modeling of the underlying variable’s distribution.
• Indirect modeling of the underlying variable’s distribution (via a
Monte Carlo technique).
 Significant Long-term Trends
• Some weather elements have trended significantly.
• Trends need to be considered when valuing weather securities
(such as CDD Call Options).
• The trend in the minimum temperature at Melbourne (Australia) is
shown here.
 Cooling Degree Days (1855-2000)

• The chart shows frequency distribution of annual accumulated

Cooling Degree Days at Melbourne using all data:
 Cooling Degree Days (1971-2000)

• The chart shows frequency distribution of annual accumulated

Cooling Degree Days at Melbourne using only recent data:
 Pricing the CDD Call Option
• The two CDD frequency distributions are quite different.
• Utilising the different data in valuation results in different prices.
• Utilising 1855-2000 data yields a price thus: $
(.051x2500+.045x7500+.008x12500)= $565.00
• Utilising 1971-2000 data yields a price thus: $
(.238x2500+.119x7500+.029x12500)= $1850.00
• The more recent frequency distribution should provide a more
relevant result.
 An Option linked to a Climate Index
• Suppose we define a rainfall put option, to apply when the
Southern Oscillation Index (SOI) is in the lowest three deciles.
• Location: Echuca.
• Strike: Decile 4.
• Notional: $100 per decile below Decile 4.
- If, at expiry, the rainfall Decile is less than 4, then the seller of
the option pays the buyer $100 for each Decile below 4.
Pay-off Chart for Decile 4 Put Option
 Rainfall Distribution
• To value the put option one uses data giving actual distribution of
rainfall for cases when the SOI is in the lowest 3 deciles.
 Evaluating the Decile 4 Put Option

• 9 cases of Decile 1 yields $(4-1)x9x100=$2700

• 6 cases of Decile 2 yields $(4-2)x6x100=$1200
• 4 cases of Decile 3 yields $(4-3)x4x100=$400
• The other 25 cases (Decile 4 or above) yield nothing.
…leading to a total of $4300, and an average contribution of $98, which is the price of our
put option.
• Later, a catastrophe bond, which may be issued to provide protection in the case of
drought, will be described.
 Impact of Forecasts

• When very high temperatures are forecast, there may be a rise

in electricity prices.
• The electricity retailer then needs to purchase electricity (albeit
at a high price).
• This is because, if the forecast proves to be correct, prices may
“spike” to extremely high (almost unaffordable) levels.
 Impact of Forecast Accuracy

• If the forecast proves to be an “over-estimate”, however, prices

will fall back.
• For this reason, it is important to take into account forecast
verification data in determining the risk.
 Using Forecast Verification Data

• Suppose we define a 38 deg C call option (assuming a

temperature of at least 38 deg C has been forecast).
• Location: Melbourne.
• Strike: 38 deg C.
• Notional: $100 per deg C (above 38 deg C).
• If, at expiry (tomorrow), the maximum temperature is greater than
38 deg C, the seller of the option pays the buyer $100 for each 1
deg C above 38 deg C.
Pay-off Chart: 38 deg C Call Option
 Determining the Price of the
38 deg C Call Option

• Between 1960 and 2000, there were 114 forecasts of at least

38 deg C.
• The historical distribution of the outcomes are examined.
Historical Distribution of Outcomes
 Evaluating the 38 deg C
Call Option (Part 1)
• 1 case of 44 deg C yields $(44-38)x1x100=$600
• 2 cases of 43 deg C yields $(43-38)x2x100=$1000
• 6 cases of 42 deg C yields $(42-38)x6x100=$2400
• 13 cases of 41 deg C yields $(41-38)x13x100=$3900
• 15 cases of 40 deg C yields $(40-38)x15x100=$3000
• 16 cases of 39 deg C yields $(39-38)x16x100=$1600
cont….
 Evaluating the 38 deg C
Call Option (Part 2)
• The other 61 cases, associated with a temperature of 38 deg C
or below, yield nothing.
• So, the total is $12500.
• This represents an average contribution of $110 per case,
which is the price of our option.
 A Forecast Error Put Option
(defining error as predicted minus observed)

• Strike: 0 deg C.
• Notional: $100 per degree of forecast error below 0 deg C
• If the forecast underestimates the actual temperature, then the
seller of the option pays the buyer $100 for each 1 deg C of
underestimation.

- Historical simulation yields a suggested price of $67 for our put

option.
 Particularly Australian Applications

• Purchase of put contracts to protect against reduced rainfall, by

a generator of hydroelectricity.
• Purchase of call contracts to protect against a sequence of very
hot days.
• Purchase of variable degree day contracts to protect against
very high temperatures.
• Purchase of guaranteed yield contracts (based on relationships
between wheat yield & rainfall and temperature).
 Ensemble Forecasting

• In order to obtain a measure of forecast uncertainty, there is an

alternative to using historical forecast verification data.
• This is to use ensemble weather forecasts
• Ensemble weather forecasts are derived by imposing a range
of perturbations on the initial analysis.
• Uncertainty associated with the forecasts may be derived by
analysing the probability distributions of the outcomes.
 Concluding Remarks

• The sophistication of weather-related risk management

products is growing.
• Australia has joined this new market.
• In evaluating weather securities, one may use a variety of data
types, and take into account climate trends.
• Ensemble forecasting is an alternative approach to determining
forecast uncertainty.
 Recommendations
• In order to keep abreast of developments in this growing sector
of weather services…
- That the BoM join the Weather Risk Management Association.
- That the BoM be represented at risk management conferences.
- That the BoM develop a program of research into weather risk
management.
- That the BoM subscribe to a variety of risk management
journals.