Valerie Denney explains what weather derivatives are all about.

Just as professionals regularly use futures and options to hedge their risk in interest rates, equities and foreign exchange, there are now tools available for the management of risk from extreme variations in weather. These products represent the fastest growing derivative market today. No wonder, then, that weather derivatives and weather risk management in general continue to be popular conference topics.

So what exactly do these new-fangled derivatives do? Designed to help businesses hedge against the impact of unexpected weather on earnings, a weather derivative has a payoff derived from one or more independently measurable factors such as temperature, rainfall, wind speed, snow depth or sunshine hours as recorded at one or more specified reference locations. Properly used, these derivatives can limit revenue loss (or guarantee a minimum revenue stream) and improve the accuracy of budget forecasting for planning purposes. The majority of weather deals at present are swaps or options based on underlying temperature indices at single locations. It is also possible to structure hybrid deals with payouts based on a combination of two or more weather underlyings such as precipitation and temperature.

Weather derivatives differ from conventional derivatives in that there is no original, negotiable underlying or price of an underlying, which usually forms the basis of the contract. While financial derivatives are based on share prices, bonds, exchange rates or currencies, weather derivatives are based on weather conditions data which have an influence on the trading volume of some goods. However, some transactions can combine volume and price risks by adopting a multiple-trigger approach. A trucking company, for example, could employ a double-trigger derivative to protect itself against extreme snowfall and a simultaneous increase in diesel prices.

As already noted, most weather deals thus far have taken the form of swaps or options addressing fluctuating temperatures. Temperature-based transactions are usually measured in degree days, which are a measure of the variance of the average temperature for each day from a standard reference temperature. A heating degree day (HDD) measures how low the daily average temperature is relative to 650F. This is the outside temperature below which consumers tend to turn on heat. HDDs are typically used during winter. If the average daily temperature is 400F, for example, the HDD for the day would be 65 - 40, or 25. If the average temperature is greater than or equal to 650C, the HDD would be zero.

A cooling degree day (CDD) measures how high the daily average temperature is relative to 650F, which is the outside temperature above which consumers usually switch on their air-conditioning units. CDDs are commonly used in summer. If the average temperature is 680F, the day's CDD would be 68 - 65 or 4. If the average temperature is less than or equal to 650C, the CDD would be zero.

It's worth pointing out that while 650F is a relevant baseline to use in the energy world, other industries can establish baselines more applicable to the risks they face. Agriculture-based contracts, for instance, can be set to trigger when there are more than a certain number of days with minimum temperatures in the freezing range over a designated period of time.

A typical temperature-related derivative could entail a company taking out a 30-day CDD swap. At an average temperature of 750F during this period, the company is due 300 (30 x 10) degree days multiplied by a predetermined sum for each degree day. Had an HDD swap been used, the company would have owed the same amount of money.

Consider the example of an agricultural firm which is negatively impacted if the temperature is too cool during the growing season, reducing the amount of crops that will be harvested. In order to hedge this risk, the firm purchases a CDD put for an agreed period with a strike level of 610 CDDs for $260,000. The firm receives $5,000 for each degree the actual CDD level is below 610 CDDs. If the actual number of CDDs exceeds 610, no payment is made. This provides the firm with cash compensation if the temperature is too low for effective growing days.

There's more
In keeping with a relatively new market, products continue to evolve. Other weather risk management tools are being developed which address precipitation, snow pack, wind and stream flow risk. In the case of precipitation risk, for example, an amusement park could purchase a precipitation call for a pre-determined period with a strike level of 24.5 inches for $200,000. The park receives $25,000 for every one tenth of an inch the actual precipitation level exceeds 24.5 inches. This gives the park cash compensation if there is an excessive amount of rain during the summer resulting in dropped attendance.

A wide range of structures and applications is currently available, usually customised to fit customers' hedging needs. Hence the domination to date of the OTC market.

That the weather derivatives market will continue to grow is not in doubt, although liquidity and lack of price transparency remain concerns. In addition, many end-users have yet to realise the potential of these products, still overlooking weather as a real risk to be managed. However, when you consider that in the US alone over $1trn is lost to the vagaries of weather each year, the sooner weather is factored into the risk equation the better. As one observer puts it: "If companies aren't using the derivatives option, they are betting on the weather which is not a sound strategy for a large corporation."

Rough guide to the jargon

Average daily temperature
The mean of the actual daily high and actual daily low temperatures.

Basis risk
Risk that continues after hedging due to the difference between the theoretical instrument which would hedge risk completely and the one used in practice.

The standard unit employed when determining the strike. The typical CDD/HDD benchmark is 65oF.

Call option (weather cap)
Where the buyer pays a premium to a seller for the possibility of receiving a payout if the actual index amount is greater than a predetermined strike when the contract settles.

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

Compound option
Companies wary of locking into an option can use this instrument, in which they pay only a fraction of the premium up front and later - usually after evaluating updated long-range forecasts - have the option of entering fully into the structure.

A legal entity with which deals are made.

Cumulative degree days
The sum of the daily HDDs or the sum of the daily CDDs over a stipulated period.

Digital option (also known as a binary option)
Producers hedging against massive demand spikes can use digital structures, in which a single lump-sum payment is agreed when the temperature hits a certain strike.

Energy degree days
A derivative that is derived from HDDs plus CDDs.

The conversion of the option into the underlying commodity.

Exotic option
An option other than a `plain vanilla' option.

Floors (put options)
These provide buyers with a cash payout based on the difference between the strike and the actual index value. If the index value exceeds the strike, no payment is made. As with a cap (call option), buyers must pay a premium to the floor seller.

A forward contract which trades on an organised exchange, enabling traders to take a market position at a future date.

The act of taking an equal and opposite position with futures or another financial derivative instrument to the physical position held.

Hybrid deals
These are structured in such a way that payouts depend on a combination of two or more underlyings, such as CDDs and precipitation.

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

In-the-money option
A condition where an option has a positive intrinsic value. A call option is in-the-money when the price of the option's underlying security is higher than the strike value. The opposite applies in the case of a put option.

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

A system of trading whereby the owner has 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 cash settlement if the underlying index reaches a predetermined strike. If there is no value in the deal at expiry, the option will not be exercised.

Out-of-the-money option
When an option has no intrinsic value. A call option is out-of-the-money when the value of the underlier is lower than the strike value. The opposite applies with a put option.

Over the counter (OTC)
A contract struck between two counterparties, as opposed to being traded on an exchange.

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

Stochastic process
A random process which evolves over time.

Also known as strike price, this is a predetermined level where an option payout occurs.

An agreement to settle in cash 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 price.

The smallest increment an index can move by. Most HDD deals have a tick size of 1HDD. Alternatively, the term can factor in contract size. In the case of the Chicago Mercantile Exchange's HDD futures, which have a contract size of $100 per HDD and a minimum increment of 1HDD, the tick size is $100 per HDD.

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

Weather exposure
The weather's impact on a company's revenue.

By Valerie Denney