With the mess created by complex credit derivatives, the appetite for playing with fire may have taken a back seat. But in the world of derivatives, new experiments are always in the offing. Now, you can try playing with the wind speed, rainfall, snowfall or even daily variation in your city temperature by using what are known as weather derivatives.
There can be as many types of weather derivatives as there are types of weather conditions. Some of these weather derivatives are becoming very popular in international financial markets. It might take some time before these products are available in the Indian market. But when El Niño is around, can weather derivatives remain far behind?
Johnny: Before we can even think of using a weather derivative, we should know what exactly a weather derivative is. Can you explain that, Jinny?
Jinny: As you may be aware, any derivative product derives its value from some underlying asset. For instance, single-stock futures contracts derive their value from the value of underlying stock. The value of interest rate futures contracts are derived from the rise or fall of some underlying benchmark interest rates.
For designing a derivative product, you always need to have something to act as an underlying. Weather derivatives use weather conditions—such as city temperature, rainfall and wind speed and so on—to create different kinds of derivative instruments.
The value of a weather derivative is derived from fluctuations in weather conditions. For instance, the rise or fall in a city’s temperature may determine the value of a weather derivative based on that. Although you can’t put a price tag on wind speed, rainfall or temperature, weather conditions do fluctuate like the price of your stocks and bonds. That’s what enables the creation of weather derivatives that work just like any other derivative.
Illustration: Jayachandran / Mint
Johnny: But I don’t understand. In what way is a weather derivative useful?
Jinny: That’s not difficult to explain. Weather derivatives serve as a tool for hedging the economic loss arising from variations in weather conditions.
These derivatives focus on day-to-day variations in weather conditions and not on one-off disasters such as hurricanes or cyclones that are taken care of by insurance.
Day-to-day variations happen frequently and have a more subtle effect on the profitability of many businesses. For instance, a rise or fall in temperature may have an effect on the sale of ice creams. Similarly, the amount of rainfall decides the fate of our crops and wind speed may affect the viability of a wind power project.
Weather derivatives bring together those who want to hedge their risk and those who want to assume the risk. It makes trading of weather risk possible in the form of a financial instrument. A party willing to protect himself from the vagaries of nature transfers his risk to someone who is willing to play the role of an adventurous risk-taker by taking a fee. In case nature remains within its expected limits, the risk-taker earns a profit; however, in case of greater fluctuations, the risk-taker has to take a loss.
The remarkable thing is that the profit or loss arising out of a weather derivative is not correlated at all with the trends in the financial market. Stock or bond markets may rise or fall together.
But a rise or fall in the city temperature has nothing to do with the rise or fall in the stock market indices. A weather derivative remains unaffected by the general mood of the financial market. Investments that aren’t correlated have their own charm for some investors.
Johnny: It really sounds like a new discovery. Can you tell me how much the weather derivatives market has evolved so far?
Jinny: Well, the first transactions relating to weather derivatives were undertaken in 1997 in the US. Initially, all weather derivative contracts used to take place on the basis of one-to-one negotiations between the contracting parties, in what we call over-the-counter transactions.
However, the international financial market didn’t take much time to realize that if they are able to quantify weather in terms of monthly or seasonal variations and put a price tag on each variation from the average, then they could very easily trade changes in weather just like any financial instrument.
The Chicago Mercantile Exchange of the US created the first exchange-traded weather futures contracts and options on futures in 1999 based on the index of monthly variations in daily city temperature called heating degree days (HDDs) during winters and cooling degree days (CDDs) during summers.
Both HDDs and CDDs are calculated according to how many degrees the temperature varies from a baseline temperature of 65 degrees Fahrenheit (18.3 degrees Celsius). The market is developing well in the US and to some extent in Europe.
The main players currently active in international weather derivatives market are energy companies, insurance companies, hedge funds and even some banks. With the passage of time, we may well see weather derivatives reaching different nooks and corners of the world.
Johnny: That’s true, Jinny. Playing with nature is mankind’s oldest hobby.
What: Weather derivatives use day-to-day variations in weather conditions as an underlying asset.
Why: Weather derivatives are useful in preventing losses arising from variations in weather conditions.
Where: Weather derivatives are becoming popular in the US and, to some extent, in European markets.
Shailaja and Manoj K. Singh have important day jobs with an important bank. But Jinny and Johnny have plenty of time for your suggestions and ideas for their weekly chat. You can write to both of them at firstname.lastname@example.org