Weather derivatives

History
The first form of weather derivative came as a contract between two energy companies,
Consolidated Edison (ConEd) and Aquila Energy(Aquila) in the year 1996. The contract
stated that ConEd would purchase power from Aquila. The price of power was fixed and
agreed for the month of August. But if August turned out to be cooler than expected,
Aquila will have to pay ConEd a rebate. The measurement of this was referenced to
Cooling Degree Days (CDDs) measured at New York City's Central Park weather station.
The market for weather derivates soon started to grow and by 1999 Chicago Mercantile
Exchange (CME) released the first exchange traded weather futures contract. One of the
early major pioneer in weather derivatives was Enron Corporation.

Weather derivatives today

The weather
derivatives market is
still growing today,
however majority of
contracts are still
written over the
counter (OTC).
Growth of the
market on the CME
is present but the
volume traded is low
resulting into
making the product
illiquid, often
creating a large
bid/Ask spread. The
global market for
weather derivatives
is also still growing
but is facing
problem with high
barriers to entry,
pertaining to
weather data and
quality of said data.
The Securities and
Exchange Board of
India (Sebi) plans to
allow trading in
weather derivatives in India. It is difficult to collect reliable weather data for

sustainability of the product. There are also regulatory issues needing to be sorted. And, it
involves a high risk cost.

Basics of Weather derivatives

The main purpose of a weather derivative is to hedge risk, and maintain revenues. It
achieves this by promising the payoff based on weather. One of the standard forms of
weather derivatives are based on Heating Degree Days (HDD) values. These values
represent temperatures for days on which energy is used for heating. And Cooling Degree
Days (CDD) ,which represent temperatures for days on which energy is used for air
conditioning. Both HDD and CDD values are calculated according to how many degrees
a day's average temperature varies from a baseline of 65 Fahrenheit. The reason for 65 is
it is minimum temperature for human comfort. The most common type of weather
derivative is one that deals with temperature. There are other types too that would deal
with events like rainfall, snowfall, wind speeds, hail and more.

Measuring daily index values

1. Heating Degree Days:
HDD= Max(0, 65-A)
where A is the average
Temperature at specific
weather station during
the day. If the outcome of
65-A is negative then it is
adjusted to 0, as HDD
cannot be negative. This
is because theoretically
there would be no need
for heating on a day
when average
temperature is greater
than 65
2. Colling Degree Days:
CDD= Max(0, A-65)
where A is the average
temperature for the day.
Like HDD, CDD also
cannot be negative.
The table alongside is showing
daily average temperatures and
corresponding HDD and its impact on the contract.
For European cities, CME's weather futures for the HDD months are calculated according
to how much the day's average temperature is lower than 18 Celsius. However CME
weather futures for the summer months in European cities are based not on the CDD

index but on an index of accumulated temperatures, the Cumulative Average Temperature

(CAT).
The CME CAT Index is the accumulation of daily average temperatures over a calendar
month, with the accumulation period beginning on the first calendar day of the contract
month and ends with the last day of the contract calendar month. Cumulative Average
Temperature (CAT) contracts are available for summer months in Europe, allowing
businesses to hedge against monthly volatility by tracking average daily temperature in a
given city.

Weather Options
Weather options can be created with mix of components according to the hedging
requirements. Components used depends on the type of contract, period of contract,
underlying index, a temperature & rainfall data according to demographics, strive level,
tick size and payout cap.
Contract Type:
There are two types of basic option contracts, which can be used for creating weather
option. Calls are bets that indicate underlying index value will be higher than the strike
level, while puts are bet that indicate index value will be lower. The higher value for Call
or lower index value in case of Puts is from the strike price, more would be the profit
gained to the owner of the option. Further hedging strategies can be used to make option
contracts that are less volatile.
Contract Period:
The contract period is the time frame in which the contract will encompass, whether it is
for the month, or the entire season.
Underlying Index:
The underlying index for a weather options can be Heating Degree Day, Cooling Degree
Day, average of average temperature (PRIM), cumulative averages (CAT) for
Temperature Indices & cumulative Rainfall index, Deficit Rain Index for Rain weather
indices.
Other index variables includes precipitation levels, snowfalls, wind speed, sunshine, solar
radiation etc.
Weather Station:
Data is collected from the meteorological departments and weather stations across the
world on daily basis for the valuation purposes.
CME collects data from 48 stations situated across the globe. These weather stations are
providing with all statistical data used as input to derive the index values which further
can be used for weather contracts on CME. In this type of Over the Counter (OTC)

between two firms, the firms can choose any weather station with reliable data and
mutual coordination.
Strike Level:
Strike price at which the option contract will be executed.
Tick Size:
The Tick size is the dollar amount that will be paid out per degree day the index goes
over(calls) or stays under(puts) the strike.
Payout Cap:
The payout cap is limit to the amount of ticks that will be paid out on a contract. Payout
caps are not the requirement for any OTC contracts, but are recommendable for the firms
writing the contracts.
Illustration. ABC lts is a heater manufacturing company that has a CDD call for the
month of December 2016. Weather index is derived from the average temperature from
three weather stations (Delhi, Chandigarh, Jaipur) with a call strike level of 20 degrees,
a tick size of INR 100000 per degree, and without a payout cap. The CDD index if ends
at 22, ABC would gain INR 200000 from the contract.

Valuation of Weather Derivatives

The price of a contingent claim F can be calculated as:
F=e

rT Q
E [(I)]

I: stochastic variable that expires at time T, weather index (I): payoff of the derivative at
expiration, r: risk free interest rate, EQ: risk neutral probability measure.
This valuation has several constraint because of the underlying index as weather.

Weather cannot be traded: no-arbitrage models to WD are impractical!

Black and Scholes does not work as volatility changes very frequently
Price of the derivative must account for the market price of weather risk ()
According to Benth many arbitrage-free prices can exist for this type of
derivatives
Hull defines that weather risk is not a systematic risk, this risk varies according to
demographics.

For pricing this derivatives several approaches as described can be used.

Burn analysis
Index Value Simulation
Daily simulation
Stochastic Pricing Model

Hedging Strategies for Weather Derivatives

Natural Hedging:
Companies associated with weather derivatives should spread its operation across
geographies according to correlated climates, so as companies observe positive or
negative shocks in this market in different geographies can compensate each other.
For hedging against loss due to uncertain weather conditions, company can choose from
the following strategies:
Companies can use location specific Over The Contract (OTC) derivatives. This carries
counterparty credit (default) risk but mitigates the basis risk.
Companies can also use exchange-traded derivative based on a regional weather index or
on one of CMEs fifteen city weather indices that carries basis risk but no credit risk will
be faced
Using combination strategy: Companies can buy exchange traded derivative to mitigate
majority of weather-related risk at minimal credit risk, then supplement with OTC basis
hedging derivative to decrease basis risk.

Companies that Uses Weather Derivatives

Primary purchasers of the companies that trade into weather derivatives are from energy
sector, but as this type of options are developing many other companies have also started
entering into the market. Second to energy sector, agriculture sector is also a major buyer
of these contracts for hedging against agricultural products.
Farmers also use weather options to help mitigate cost of agricultural inputs in case of
drought, high temperatures or in flood like situations. Other businesses that have started
entering are beverage companies, construction companies, municipal governments, travel
and related companies. All of these companies mainly use this option to mitigate risk and
maintain revenues.

Weather Derivatives in India

Through inception of currency future & options, commodity future & options, global
indices Derivatives it seems that weather trading would also be introduced and just like
future contracts proved boon to farmers for commodities, weather derivatives can also
follow the trend.
The big task is the strong regulatory and an efficient infrastructure needs to be build since
issues of inflation and global warming are a big concern to this markets. Weather
derivatives have to be streamlined along with the multiple regulatory authorities like
FMC for commodities & SEBI for Securities.
A proper exposure and education about the benefits of weather derivatives should be
imparted to farmers and traders associated with these sectors. They must be
communicated that, how by exercising weather derivatives they can hedge their risks in
an easier approach rather than losing money due to other abnormalities.
Weather derivatives can be a success in India if

Appropriate measures are undertaken to minimize basis risk

Realistic weather derivative products are designed
Sustainable and attractive pricing
Timely payout

On the basis of the empirical studies done in other emerging economies and the observed
success rates of weather derivatives in that markets similar conclusions can be drawn for
the potential of such instruments in Indian markets. With regard to the significance of
agriculture and power sectors in the Indian economy and their vulnerability to weather
factors, the need for evolving an adequate, sustainable weather risk management system
should be duly recognized.
With the growth in financial markets, Indian economy is apt for adopting weather
instruments. Besides the present trend of integrating the Indian financial sector with the
global market may be expected to contribute to the growth and success of the derivatives
market in terms of participation of foreign players and raising the level of competition.

References:
http://www.Investopedia.com
http://www.zenithresearch.org.in/images/stories/pdf/2012/May/ZIJBEMR/11_ZIBEMR_
VOL2_ISSUE5_MAY2012.pdf
http://www.hec.unil.ch/cms_mbf/master_thesis/0004.pdf