A.

A

Arbitrage

A transaction that generates a risk-free profit by exploiting differences in instrument prices across two markets.

At the money

A condition where the value of an option's underlier matches the option's strike price.

See also: In the money, Out of the money

Average daily temperature

The mean of the actual daily high temperature and the actual daily low temperature, ie (Tmax + Tmin ) / 2).

B

Basis risk

Risk that remains after hedging due to the difference between the theoretical instrument that would hedge a risk completely and the instrument that is used in practice. Reduction of basis risk becomes progressively more expensive in general, so risk management decisions need to account for the increasing premium cost versus lowered basis risk.

Basket

Two or more reference stations that are used in determining the specifics of a transaction. The measurements from reference stations in a basket can be either aggregated or average weighted.

Benchmark

The standard unit used in determining the strike. In the case of heating degree days (HDD), the typical benchmark would be 65°F, or for a Tmax transaction in Des Moines, Iowa, the benchmark may be 100°F.

Beta

A measure of systematic risk.

Binary option (also known

as digital option)

A type of option that features a discontinuous pay-off.

C

Calculation period

The period from the effective date to the termination date (inclusive) of a transaction.

Call option (weather cap)

A contract where the buyer pays a premium to a seller for the potential to receive a payout if the actual index amount exceeds a predetermined strike when the contract settles. For example, an HDD call option is purchased to protect against exposures to high numbers of HDDs, perhaps to provide offsetting cover for a provider of “burst pipe” damage insurance.

Cap (also known as Limit or Maximum payout)

The maximum payout of an option.

Capital Asset Pricing Model (CAPM)

A model for valuing financial assets based upon their systematic risk.

City spread

The sale of a contract struck on a reference location in one city against the purchase of a second contract struck on a reference station in another.

Collar

A contract where the buyer purchases an out-of-the-money call option and sells an out-of-the money put option. Typically, little or no premium is exchanged. This provides protection against reduction in revenue in return for foregoing a proportion of potential upside.

Compound option

An option on an option, where the buyer pays an up-front premium. If the buyer exercises the option, the buyer must pay an additional premium (the exercise premium) by a certain date (the exercise date).

Contract (tick) size

See Tick size

Confirmation

A written notice confirming the details of a transaction.

Cooling degree day (CDD)

A term created by the energy sector to translate temperatures into a proxy for levels of air conditioning demand. It is measured as the difference between a reference temperature and the actual temperature (as determined by the average of the high and low daily temperatures).

The reference is typically 65°F in the US (18°C, its nearest Celsius equivalent, in Europe) as this is the outside temperature above which consumers tend to turn on their air conditioning systems). For example, if the daily high temperature is 72°F and the daily low is 66°F, the actual temperature for that day would be 69°F. The CDDs for that day would be 4 (69-65). If the average temperature is less than or equal to 65°F, the CDDs for the day would be zero. CDDs are typically used to hedge exposures to cool weather during the summer season (May to September).

Correlation

A measure of the extent to which a set of variables are interdependent.

Counterparty

A legal entity with which deals are made.

Credit risk

The risk that a counterparty may default on its obligations.

Critical Day Options

Options where the payoff is a function of critical days. A day is termed critical if certain defined conditions are met. For example a contract may stipulate that a day is “critical” should the temperature rise to at least 25°C (77°F) at some point during the day. The option's payoff now becomes a result of the number of critical days rather than a cumulative degree day or temperature total.

Cumulative degree days

The sum of the daily HDDs or the sum of the daily CDDs over a specified period.

D

Degree day

The deviation of a one-day average temperature from a defined reference temperature. The reference temperatures typically used are 65°F in the United States and 18°C in Europe. Degree days can be “heating” or “cooling”. See also Heating degree days, Cooling degree days.

Delta

A measure of exposure to an underlier.

Derivative instrument

A financial instrument, the price or value of which is derived from the performance of an underlying instrument or index.

Digital option (also known

as binary option)

See Binary option.

E

Earth Satellite Corporation (EarthSat)

The independent service firm designated by the Chicago Mercantile Exchange (CME) to define the degree days indices to which the weather futures and options contracts are tied.

El Niño

El Niño is a periodic warming of the tropical Pacific ocean that affects weather around the world and occurs roughly every 3-5 years. Typical consequences of El Niño include increased rainfall in the southern US and drought in the western Pacific. Winter temperatures in the north-central states of the US are typically warmer than normal in El Niño years and cooler than normal in the southeast and southwest of the country.

Enterprise risk management

The process whereby an organisation optimises the manner in which it takes risks.

European

European options can be exercised only on the expiration date. Most weather options trade as Europeans.

Exchange traded

Instruments traded on an exchange such as the CME or London International Financial Futures Exchange (LIFFE), as opposed to being traded over the counter.

Exotic Option

An option whose payoff at maturity depends on the values taken by the underlying asset over the whole lifetime of the option rather than the single value at maturity.

Expected value

The mean of a random variable. Calculated by aggregating the values the variable takes multiplied by the likelihood of each outcome.

Exposure

Sensitivity to a source of risk.

F

Fair Value

The expected value of the option payoff under the appropriate distribution. In general, this will be less than the premium.

Final settlement

The final settlement price for each monthly contract is based upon the HDD or CDD indices calculated by EarthSat.

Financial engineering

The design of financial portfolios to achieve specified goals.

Financial risk

Financial exposure to uncertainty.

Financial risk management

The process whereby an organisation optimises the manner in which it takes risks.

Forward

An agreement to execute a transaction at some time in the future.

Future

An agreement to execute a transaction at some time in the future.

G

Gamma

A measure of second-order exposure to an underlier.

Good till cancelled (GTC)

An order that remains open until cancelled and can be filled at an undesirable time if forgotten.

Greeks

A set of factor sensitivities frequently used for measuring the exposures of derivative portfolios.

Growing degree days

An index used by the agricultural industry. Typically calculated by subtracting a base value (eg 50°F) from the mean daily temperature. The mean daily temperature is calculated after amending the minimum and maximum temperatures. The minimum temperature for a given day is taken as the higher of the actual minimum temperature and the base value chosen. The maximum temperature for a given day is taken as the lower of the actual maximum temperature and a defined maximum limit (eg 86°F). The rationale for this is that there is no further impact due to temperature on crop growth at temperatures above the maximum limit or below the base level.

GDD = [(min{maximum temp limit, daily maximum temp} + max{base temp

level, daily minimum temp})÷2] - base

H

Heating degree day (HDD)

A term created by the energy sector to translate temperatures into a proxy for levels of heating demand. It is measured as the difference between the actual temperature (as determined by the average of the high and low daily temperatures) and a reference temperature. The reference is typically 65°F in the US (18°C, its nearest Celsius equivalent, in Europe) as this is the outside temperature below which consumers tend to turn on their heating systems).

For example, if the daily high temperature is 55°F and the daily low is 35°F, the actual temperature for that day would be 45°F. The HDDs for that day would be 20 (65-45). If the average temperature were greater than or equal to 65°F, the HDDs for the day would be zero. HDDs are typically used to hedge exposures to mild weather during the winter heating season (November to March).

Hedging

The act of reducing risk, often through use of financial derivative instruments.

Heteroscedasticity

Non-constant volatility.

High-yield bond

A bond that pays a high yield due to significant risk, for example catastrophe bonds (insurance losses) and junk bonds (credit risk).

Historical value at risk

A method for estimating value at risk using historical data.

Hybrid deals

Deals structured so payouts depend on a combination of two or more underlyings, such as HDDs and precipitation.

I

Implied volatility

An estimate of volatility based upon market prices of relevant options.

Index

The index is the cumulative number of degree days (or other type of weather condition) over a period for a particular location as measured by the relevant national meteorological office.

In the money

A condition where an option has a positive intrinsic value. A call option is in the money when the value of the option's underlier is higher than the option's strike value. Conversely, a put option is in the money when the value of the option's underlier is lower than the option's strike value.

See also Out of the money and At the money

L

Legal risk

Risk relating to legal uncertainties.

Limit (also known as Cap or Maximum payout)

The maximum payout of an option.

Liquidity

A measure of an asset's ease of trading. The higher the liquidity, the less impact individual (large) trades have on an asset's price.

Liquidity risk

Risk from a lack of liquidity.

Lognormal distribution

A type of probability distribution.

Long position

A position that entails ownership or effective ownership of an asset.

M

Market value

The value at which an asset trades, or would trade in the market.

Mark-to-market

Risk exposure based upon the current market values of a counterparty's obligations.

Maximum exposure

The largest potential loss arising from a particular risk.

Maximum payout (also known as Cap or Limit)

The maximum amount that the seller of an option or a swap participant may be obligated to pay.

Mean

The aggregate of the values taken by a random variable multiplied by the likelihood of each outcome.

Mean reversion

A tendency for a stochastic variable to drift toward a long-term mean level.

Meteo France

National meteorological office of France.

Meteorological Office (Met Office)

The national meteorological office of the UK.

Model risk

Risk from the misuse of financial models.

Modern portfolio theory

A body of theory relating to how investors optimize portfolio selections.

Monte Carlo simulation

A technique of simulation which uses many randomly or “pseudo randomly” generated scenarios.

Monte Carlo value at risk

A technique for estimating value at risk that is based on Monte Carlo simulation.

N

National Climatic Data Center (NCDC)

The government agency responsible for the collection and dissemination of climatic data. It is the independent source upon which most US weather transactions are based.

National Weather Service (NWS)

The division of the National Oceanic and Atmospheric Administration responsible for providing weather and flood warnings, public forecasts, and advisories for all of the US, its territories, adjacent waters and ocean areas.

Normal distribution

A probability distribution often assumed in financial modeling but with limited applicability to the weather market.

Notional amount

The quantity of an underlier to which a derivative contract applies.

O

Option

A contract that gives the owner the right, but not the obligation, to exercise the terms of the contract. The buyer pays a premium to the seller for the right to a payout if the underlying index reaches a predetermined strike. Weather options include a premium, a period, a location and a payout. The maximum payout is the maximum upside for the buyer of an options contract. The premium is the maximum upside for the seller (or “writer”) of an option contract. If at option expiry there is no value in the deal, then the option will not be exercised.

Option expiry

The end of the option. This is the date when the holder has the right but not the obligation to exercise the contract.

Option payout

The amount that the option will pay the holder at the end or expiry of the contract.

Option writer (also known as the Principal)

The seller of an option.

Out of the money

A condition where an option has no intrinsic value. A call option is out of the money when the value of the option's underlier is lower than the option's strike value. Conversely, a put option is out of the money when the value of the option's underlier is higher than the option's strike value.

See also In the money and At the money

Over the counter (OTC)

A contract struck between two counterparties, as opposed to being traded on an exchange.

P

Payout

The dollar amount an option buyer or swap participant receives at settlement of the contract.

Premium

The price paid to purchase an option or other financial instrument.

Principal (also known as Option writer)

The seller of an option.

Probability distribution

The set of values describing the likelihood of occurrence for each possible outcome of a random variable.

Put-call parity

A formula that relates the price of a put to the price of a corresponding call.

Put option (also known as Weather floor)

A contract where the buyer pays a premium to a seller for the potential to receive a payout if the actual index amount is less than a predetermined strike when the contract settles. A weather floor is purchased with the expectation of mild temperature or precipitation.

See also Floor

R

Reference station

Specific location at which weather variable is measured under the terms of a trade. Several cross-referenced identifiers, including WBAN (Weather Beacon Army Navy code), WMO (World Meteorological Organisation), and latitude, longitude and elevation coordinates, identify this location (eg Boston Logan International Airport, WBAN #14739, WMO# 72509, 42° 22'N latitude, 71° 01'W longitude, 6.1m elevation).

Reference temperature

A benchmark temperature value used to calculate certain weather indexes. For example, 65°F is a reference temperature commonly used in calculating heating and cooling degree days.

Risk

Exposure to uncertainty.

Risk-free rate

A theoretical interest rate at which an investment may earn interest without incurring any risk.

Risk limit

A procedural tool for managing risk.

S

Scenario

A possible set of future events.

Securitisation

The creation of security interests in an asset.

Sensitivity

Exposure to a risk factor.

Shoulder months

The months between the winter (November to March) and summer (May to September) “seasons” - April and October - which are characterised by wide differentials in actual temperatures from year to year.

Simulation

Analysis based on determining the consequences of possible scenarios.

Skewness

A measure of the asymmetry about the mean of a probability distribution

Specific risk

Risk that is unique to a particular

asset or liability.

Speculator

A business, company or individual that places capital at risk in return for potential reward. Speculators in search of large profits are attracted by the leverage offered by derivatives. In the weather derivative market, a company can speculate by taking a long or short position in the swap market. For extra leverage they can use options.

Standard deviation

A measure of the spread or dispersion of the outcomes a random variable may take.

Statistical risk measure

A risk measure that is based upon a probability distribution relating to a risk.

Stochastic process

A random process that evolves over time.

Stop-loss limit

A market risk limit that curtails losses as they occur.

Stress test

A type of single-scenario risk measure.

Strike (also known as Strike price)

The value of the underlying index that is referenced when calculating payouts.

Swap

An agreement whereby two counterparties agree that a payout will be made based on the difference between the value of the underlying index and a defined strike point. Payment can flow in either direction depending on whether the index value is higher or lower than the strike. Typically swaps are used in preference to options when neither party wishes to make an up-front payment. This can introduce additional credit risk issues.

T

Theta

A measure of how a portfolio's value changes as a consequence of the passage of time.

Tick Size

The smallest increment that an index can move by. For example, most HDD deals have a tick size of 1 HDD. An alternative usage of the term is to factor in the contract size, so for the CME HDD futures, which have a contract size of $100 per HDD and a minimum increment of 1 HDD, the tick size is $100 per HDD.

U

Uncorrelated exposure

Exposure to a risk factor, assuming that all other risk factors will remain constant.

Underlier

A primary instrument or variable upon which the value of a derivative instrument depends.

Underlying

The security, commodity or other instrument or contract (swap, forward, futures contract) to which the option (or another derivative contract) is tied.

V

Value at Risk (also known as VaR)

Procedure for estimating the probability of portfolio losses exceeding some specified amount.

Vega

A measure of exposure in the value of an option or options to changes in volatility.

Volatility

The variability of a random quantity.

Volumetric risk

The effect of demand for a product or service on revenue.

W

WBAN

Weather Beacon Army Navy code, a numeric code defining a specific geographic weather station, as maintained by designated agencies of the US Department of Commerce. An example is John F Kennedy International Airport, WBAN# 94789.

Weather derivative

A weather derivative is a financial instrument that has a payoff derived from one or more independently measurable weather factor(s) such as temperature, rainfall, wind speed, snow depth or sunshine hours as recorded at one or more specified reference locations. The majority of weather deals at present are swaps or options based on underlying temperature indices at single locations.

Weather exposure

A quantifiable risk born by an individual or an organisation due to climatic volatility.

Weather hedge

A product that enables an organisation to either partially or fully offset the financial risk due to climatic volatility.

WMO

The World Meteorological Organization. Also a set of numeric codes defining specific weather stations. An example is Las Vegas McCarran International Airport, WMO# 72386.

  • Gautam Jain is director, Weather Risk Advisory, Tel. +44 (0) 1954 206246; e-mail info@WeatherRiskAdvisory.com