Ian Dudden charts LIFFE's involvement with the weather risk market.

As organisations become ever more aware of how their bottom line is affected by changes in temperature, companies are increasingly looking to the derivatives markets to provide effective risk management tools to control their exposure to weather related risks.

The London International Financial Futures and Options Exchange (LIFFE) was established in 1982 to provide financial market participants with better means of managing their risks in relation to foreign exchange rates and interest rates.

Today, LIFFE's customers benefit from the widest range of futures and options products offered by any electronic exchange. Contracts are denominated in five major currencies - Euro, sterling, Swiss franc, US dollar and yen, and five asset classes - bond, money market, swap, equity & equity index and commodity.

All products are available for trading on LIFFE CONNECT™ - the world's most advanced derivatives trading system.

LIFFE's involvement in the weather market began in late 1999 and in January 2000 the pilot phase of I-WeX.com (the Internet Weather Derivatives Exchange) was launched as a direct response to this fledgling market. I-WeX.com was developed as a partnership between IFS, Willis and LIFFE with the aim of encouraging the transparency of the over the counter (OTC) market and the growth of standardised cleared weather contracts, by acting as an information portal.

The system was launched by Patricia Hewitt, then UK Minister for Small Business and E-commerce, at a briefing attended by over 130 people. Businesses from the investment banking, energy, commodity and insurance sectors were represented. Other organisations such as weather risk consultants, local authorities and weather data providers attended the launch too.

The diverse array of attendees underlined the significant potential for growth in the weather market, although barriers to entry such as credit risk and provision of data remained. LIFFE realised that as a regulated exchange, it could play an important role in developing the weather market by helping to eliminate these potential barriers.

As awareness in the European weather market continued to grow, albeit not as quickly as in the US, LIFFE continued to monitor the developing OTC market. The exchange began a consultation process with key market participants in the energy, insurance, agricultural and weather broking sectors, some of which included Aquila, Centrica, Enron, Hiscox, Innogy and Société Générale, seeking their views on the possible shape of a regulated exchange traded weather market.

The primary areas of discussion revolved around what type of temperature calculation would form the basis of the derivatives contract and for which locations. The following was agreed by the key market players in conjunction with LIFFE.

  • The weather futures contracts should be based on average daily temperature rather than heating degree days (HDDs) and cooling degree days (CDDs) which were dominant in the energy OTC market. It was considered that average temperature provided a relevant hedge to the European market especially in light of CDDs not being applicable to Europe due to the lack of air conditioning demand, in contrast to the US. By launching contracts based on average temperature, the indices would be more simple and intuitive to encourage participation by companies in such areas as retail and insurance, as well as remaining relevant to the key energy sector.

  • London, Paris and Berlin were the key locations in Europe where OTC transactions had been focused to date and therefore these would be the most relevant initial sites on which to base futures contracts.

  • The incumbent market participants raised the exchange's awareness over the use of `caps' in the OTC market whereby a limit was often placed on the maximum payout that could be expected under a contract. However, in light of how most exchange, regulated futures markets operate, i.e. without any such price limits, it was considered that it would be inappropriate to apply caps. Moreover, caps provided security for OTC transactions where the counterparty was at risk of default. The situation was different in relation to the LIFFE market, whereby the London Clearing House (LCH) would act as a buyer to every clearing member seller and as a seller to any clearing member buyer.

  • The ability to trade both the winter season i.e. November to March and individual months should be made available.

    LIFFE determined that in accordance with the usual natural progression with regard to launching derivatives, futures contracts would be launched initially with the potential for options to be launched once the market had matured sufficiently.

    Launch of indices
    On July 10 2001, the exchange launched the www.liffeweather.com website to facilitate and promote the growth of the weather market and as a first step toward providing standardised exchange traded products. The website initially displayed monthly indices based on the monthly mean of daily average temperature for three locations - London Heathrow, Paris Orly and Berlin Tempelhof. In October 2001, winter season indices (based on the same locations but for the November to March period) were added to the website.

    The liffeweather.com website updates every day at 14.00 with the daily average temperature for the previous day (two days earlier in the case of Paris). In addition, at least ten years of historical data is available to download, free of charge.

    Launch of LIFFE weather futures
    December 10 2001 marked the launch of the world's first weather derivative products based on average temperature to be traded on a regulated futures exchange.

    Additional trading features
    Real time transparent transactions
    Weather futures are traded on LIFFE CONNECT™. The system operates in an anonymous environment, and live bids and offers can be traded in real time. Quotes and trades are reported globally by many quote vendors and, furthermore, prices may currently be seen free of charge on www.non-financials.com or www.i-wex.com.

    The futures can be traded by either becoming a LIFFE member or by routing orders through a member (by telephone or electronically). Trading takes place by submitting an order, via a trading application (front-end software), into the system's central limit order book. Having received the orders, the LIFFE CONNECT™ trading host then matches them in the central limit order book.

    Customers may access the market through LIFFE's global network, which offers wider distribution than any other electronic trading system in the world.

    Management of counterparty risk
    The LCH has a fundamental role in managing risk within the marketplace, acting as a central counterparty for all trades made on the LIFFE market. As all trades must be cleared, all members must have an assured route to the LCH.

    Only clearing members (i.e. a member of both LIFFE and the LCH) may be a counterparty to the LCH and therefore non-clearing members (i.e. those who are not also members of the LCH) must enter into a clearing agreement with a clearing member. Where a customer deals through a non-clearing member of LIFFE, the customer has no contractual relationship with the LCH and therefore their counterparty is their broker.

    As part of its role in managing risk, the LCH requires clearing members to pay initial and variation margin.

    The future for LIFFE in the weather market
    The exchange has been delighted with the market's response to the launch of its weather futures contracts, with the first trade taking place in December 2001. The London monthly index (January 2002 delivery month) was the first to trade, involving Accord Energy and Aquila Risk Management.

    LIFFE is fully supporting the growing weather market and maintains an active interest in the continuing development of I-WeX. Furthermore, consideration is already being given to a range of additional locations against which contracts could be launched during 2002.

    Although the market is still in its infancy, it offers great potential for those with awareness of the true impact of weather changes on their planned/targeted revenues.

    It is anticipated that the use of LIFFE weather futures contracts will become an important risk management instrument for anyone with a significant exposure to the unpredictability of changes in temperature.

    How are the LIFFE weather indices calculated?
    LIFFE weather futures contracts are based on the daily average temperature (DAT) for the three European locations for both the monthly and winter season contracts.

    The DAT is calculated as the midpoint in degrees centigrade between the minimum temperature of the day (Tmin) and maximum temperature of the day (Tmax), in accordance with the relevant meteorological office definitions.

    The monthly index for each location is the sum of 100 plus the mean of the DAT for each calendar day of that month.

    The winter season index for each location is the sum of 100 plus the mean of the DAT for the winter season period i.e. November 1 to March 31.

    The daily average temperature for each location is received from the domestic meteorological offices i.e. the Met Office (UK data), Meteo-France (French data) and Deutscher Wetterdienst (DWD) (German data).

    (The data recording periods by each meteorigical office may be found below.)

    What are futures?
    A futures contract (often referred to as a `swap' in the weather OTC market) is a legally binding agreement to buy or sell a commodity or financial instrument, at a specific date in the future at a price agreed today. In the case of weather derivatives, the agreement would be to buy or sell for example the average temperature for London Heathrow for a specific month. Futures contracts are standardised according to the quality, quantity per unit, price basis, delivery period and expiry date leaving the price and quantity of futures contracts to be bought/sold as the only variable to be agreed at the time of trading.

    What is initial and variation margin?
    An initial margin sum (cash or collateral) is deposited by the clearing member with the LCH on all new positions. The amount varies according to which product is being traded.

    In addition, gains and losses on open positions are calculated at the end of every day and payments reflecting those calculations, known as variation margin, are made between the LCH and clearing members. LCH receives variation margin from clearing members whose positions have fallen in value and pays it to those whose positions have risen in value.

    These arrangements between LCH and clearing members are reflected in the commercial provisions between brokers and their clients.

    The summary contract specifications for the weather futures are outlined below:
    Weather futures - monthly indices
    Contract value London: £3,000 per 1oC change
    Paris: ¤3,000 per 1oC change
    Berlin: ¤3,000 per 1oC change
    Locations London Heathrow
    Paris Orly
    Berlin Tempelhof
    Delivery months Consecutive calendar months such that 12 delivery
    months are available for trading
    Last trading day Last business day of the delivery month
    Quotation 100 plus temperature (in degrees Centigrade)
    e.g. 7.21o C = 107.21
    Minimum price movement London: 0.01 (£30)
    (tick size & value) Paris: 0.01 (¤30)
    Berlin: 0.01 (¤30)
    LIFFE CONNECT™ 10.00 - 17.00 London Time
    Trading hours
    Weather futures - winter season indices
    Contract value London: £3,000 per 1oC change
    Paris: ¤3,000 per 1oC change
    Berlin: ¤3,000 per 1oC change
    Locations London Heathrow
    Paris Orly
    Berlin Tempelhof
    Delivery months Two consecutive winter seasons,
    November 1 - March 31
    Last trading day Last business day of the March delivery month
    Quotation 100 plus temperature (in degrees Centigrade)
    e.g. 7.21oC = 107.21
    Minimum price movement London: 0.01 (£30)
    (tick size & value) Paris: 0.01 (¤30)
    Berlin: 0.01 (¤30)
    LIFFE CONNECT™ 10.00 - 17.00 London Time
    Trading hours
    These contracts are cash settled. At the maturity of each contract, LIFFE calculates a
    final closing value (known as the `exchange delivery settlement price' or `EDSP') which
    is based on the monthly or winter season index (as the case may be). Any difference
    between the traded price of the futures contracts and the EDSP is transferred between
    the buyers and sellers in cash.

    Insurance perspective
    Charles Arthur, an alternative risk transfer specialist at Hiscox, presents a personal view on the LIFFE weather futures contracts.

    As an example of alternative risk transfer and the convergence of the insurance and financial markets, the weather risk market continues to evolve dynamically and in a variety of formats. Re/insurance companies are using different routes to become involved but all are seeking the expansion of this fledgling market.

    Through a relationship with Aquila Energy, Hiscox has been actively involved in weather risk management for several years and sees LIFFE's exchange-traded products as a good example of the innovation that has been a central theme of the weather market since its inception.

    While they may not access exchange-traded derivatives markets directly, insurance groups could benefit from successful weather futures contracts, which would provide an efficient method of risk transfer. This would enhance price discovery, boost liquidity and help develop awareness, contributing to the development of the weather market.

    We welcome LIFFE's initiative and will watch its progress with interest.

    By Ian Dudden

    Ian Dudden is Director of Non-Financial Products at LIFFE.

    For further information contact +44 (0)207 379 2588, weather@liffe.com

    or www.liffeweather.com