View source for Finance:Weather derivative

'''Weather derivatives''' are [[Finance:Financial instrument|financial instrument]]s that can be used by organizations or individuals as part of a [[Risk management|risk management]] strategy to reduce risk associated with adverse or unexpected weather conditions. Weather derivatives are index-based instruments that usually use observed weather data at a weather station to create an index on which a payout can be based. This index could be total rainfall over a relevant period—which may be of relevance for a hydro-generation business—or the number where the minimum temperature falls below zero which might be relevant for a farmer protecting against frost damage.
As is the case with parametric weather insurance, there is no proof of loss provision.  Unlike "indemnity" insurance-based cover, there is no need to demonstrate that a loss has been suffered, however an indemnity insurance policy for weather is a rarely utilized instrument.  Settlement is objective, based on the final value of the chosen weather index over the chosen period. If a payout is due, it is usually made in a matter of a few days with the settlement period being defined in the contract.
See Exotic derivatives.

==Overview of uses==
Farmers can use weather derivatives to [[Finance:Hedge|hedge]] against poor harvests caused by failing rains during the growing period, excessive rain during harvesting, high winds in case of plantations or temperature variabilities in case of greenhouse crops; theme parks may want to insure against rainy weekends during peak summer seasons; and gas and power companies may use [[Physics:Heating degree day|heating degree day]]s (HDD) or cooling degree days (CDD) contracts to smooth earnings. A sports event managing company may wish to hedge the loss by entering into a weather derivative contract because if it rains the day of the sporting event, fewer tickets will be sold.

Heating degree days are one of the most common index types for weather derivative evaluation. Typical terms for an HDD contract could be: for the November to March period, for each day when the daily mean temperature falls below a reference point (65 degrees Fahrenheit in the U.S., or, 18 degrees Celsius outside the U.S.), a cumulative count is kept of the daily departures from the reference temperature.  Such an accumulation can be the basis for a derivative contract which might be structured as an [[Finance:Option|option]] ([[Finance:Call option|call]] or [[Finance:Put option|put]]) or as a "[[Finance:Swap|swap]]" that is an agreement to pay or to receive payment.

==History==
The first weather derivative deal was in July 1996 when Aquila Energy structured a dual-commodity hedge for [[Company:Consolidated Edison|Consolidated Edison]] (ConEd).<ref>{{cite web|url=http://www.environmental-finance.com/2004/0410oct/weather.htm|title=Mark Nicholls, "Confounding the Forecasts", Environmental Finance, July 4, 2008|website=environmental-finance.com|access-date=23 April 2018}}</ref> The transaction involved ConEd's purchase of electric power from Aquila for the month of August. The price of the power was agreed, and a weather clause was embedded into the contract. This clause stipulated that Aquila would pay ConEd a rebate if August turned out to be cooler than expected. The measurement of this was referenced to Cooling Degree Days (CDDs) measured at {{wipe|New York City}}'s Central Park weather station. If total CDDs were from 0 to 10% below the expected 320, the company received no discount to the power price, but if total CDDs were 11 to 20% below normal, ConEd would receive a $16,000 discount. Other discounted levels were worked in for even greater departures from normal.

Weather derivatives slowly began trading over-the-counter in 1997.  As the market for these products grew, the [[Company:Chicago Mercantile Exchange|Chicago Mercantile Exchange]] (CME) introduced the first exchange-traded weather futures contracts (and corresponding options), in 1999.  The CME  currently lists weather derivative contracts for 24 cities in the United States, eleven in Europe, six in Canada, three in Australia and three in Japan. Most of these financial instruments track cooling degree days or heating degree days, but other products track snowfall and rainfall in at ten separate U.S. locations. The CME Hurricane Index, an innovation developed by the reinsurance industry provides contracts that are based on a formula derived from the wind speed and radius of named storms at the point of U.S. landfall.

[[Company:Enron|Enron]] Corporation was one of the first to explore weather derivatives, through its EnronOnline unit.

In an ''Opalesque'' video interview, Nephila Capital's Barney Schauble described how some hedge funds treat weather derivatives as an investment class.  Counterparties such as utilities, farming conglomerates, individual companies and insurance companies are essentially looking to hedge their exposure through weather derivatives, and funds have become a sophisticated partner in providing this protection.  There has also been a shift over the last few years from primarily [[Finance:Fund of funds|fund of funds]] investment in weather risk, to more direct investment for investors looking for non-correlated items for their portfolio.  Weather derivatives provide a pure non-correlated alternative to traditional financial markets.

An online weather derivative exchange Massive Rainfall<ref>{{cite web| url = http://massiverainfall.ca |title = A Wedding Story - Massive Rainfall}}</ref> was created in 2014 and has been used to bet or hedge on specific temperatures, wind speeds and rainfall for specific days in select cities, however it appears to be only an educational tool for practice accounts in a non-existent currency.

==Valuation==

There is no standard model for valuing weather derivatives similar to the Black–Scholes formula for pricing European style equity option and similar derivatives. That is because the underlying asset of the weather derivative is non-tradeable which violates a number of key assumptions of the Black-Scholes Model. Typically weather derivatives are priced in a number of ways:

===Business pricing===
Business pricing requires the company utilizing weather derivative instruments to understand how its financial performance is affected by adverse weather conditions across a variety of outcomes (i.e. obtain a utility curve with respect to particular weather variables). Then the user can determine how much he/she is willing to pay in order to protect his/her business from those conditions in case they occurred based on his/her cost-benefit analysis and appetite for risk. In this way, a business can obtain a "guaranteed weather" for the period in question, largely reducing the expenses/revenue variations due to weather.
Alternatively, an investor seeking a certain level of return for a certain level of risk can determine what price he is willing to pay for bearing particular outcome risk related to a particular weather instrument.

===Historical pricing (Burn analysis)===
The historical payout of the derivative is computed to find the expectation. The method is very quick and simple, but does not produce reliable estimates and could be used only as a rough guideline. It does not incorporate variety of statistical and physical features characteristic of the weather system.

===Index modelling===
This approach requires building a model of the underlying index, i.e. the one upon which the derivative value is determined (for example monthly/seasonal cumulative [[Physics:Heating degree day|heating degree day]]s). The simplest way to model the index is just to model the distribution of historical index outcomes. We can adopt [[Parametric statistics|parametric]] or non-parametric distributions. For monthly cooling and heating degree days, assuming a [[Normal distribution|normal distribution]] is usually warranted. The predictive power of such a model is rather limited. A better result can be obtained by modelling the index generating process on a finer scale. In the case of temperature contracts, a model of the daily average (or min and max) temperature time series can be built. The daily temperature (or rain, snow, wind, etc.) model can be built using common statistical [[Time series|time series]] models (i.e. ARMA or [[Fourier transform]] in the frequency domain) purely based only on the features displayed in the historical time series of the index. A more sophisticated approach is to incorporate some physical intuition/relationships into our statistical models based on spatial and temporal correlation between weather occurring in various parts of the ocean-atmosphere system around the world (for example, we can incorporate the effects of El Niño on temperatures and rainfall).

===Physical models of the weather===
We can utilize the output of [[Earth:Numerical weather prediction|numerical weather prediction]] models based on physical equations describing relationships in the weather system. Their predictive power tends to be less than, or similar to, purely statistical models beyond time horizons of 10–15 days. [[Earth:Ensemble forecasting|Ensemble forecasts]] are especially appropriate for weather derivative pricing within the contract period of a monthly temperature derivative. However, individual members of the ensemble need to be 'dressed' (for example, with Gaussian kernels estimated from historical performance) before a reasonable probabilistic forecast can be obtained.

===Mixture of statistical and physical models===
A superior approach for modelling daily or monthly weather variable time series is to combine statistical and physical weather models using time-horizon varying weight which are obtained after optimization of those based on historical out-of-sample evaluation of the combined model scheme performance.

== Accounting treatment ==
In contrast to a weather insurance policy and because of its unique nature, the accounting for a weather derivative falls under specialized rules, most notably the Financial Accounting Standards Board's (FASB) Statement of Financial Accounting Standards #133 (SFAS #133). Because of this rigorous accounting and taxations treatment, any party considering the transaction of a weather derivative should seek the advice of both an accountant familiar with SFAS #133 and the required documentation, as well as a tax attorney.

==Further reading==
*Considine, G., 2000, [http://www.cmegroup.com/trading/weather/files/WEA_intro_to_weather_der.pdf "Introduction to Weather Derivatives"], Weather Derivatives Group, Aquila Energy.
*Peter Robison, [https://www.bloomberg.com/apps/news?pid=newsarchive&sid=aK9BWCFSRPnM "Hedge Funds Pluck Money From Air in $19 Billion Weather Gamble"], ''Bloomberg News'', August 2, 2007.
*USA Today (2008), [https://www.usatoday.com/weather/forecast/2008-06-09-weather-derivative_N.htm "Weather Derivatives becoming hot commodities"], USA Today Online  posted 6/9/2008.
*Alice Gomstyn, Rich Blake and Dalia Fahmy, [https://abcnews.go.com/print?id=9757635 "Want a Weather Forecast? Ask Wall Street"] ''ABC News'', February 8, 2010.
*Dischel, R. S., Ed. (2002). [http://riskbooks.com/Energy%20and%20Commodities/Climate-Risk-Weather-Market.php "Climate Risk and the Weather Market: Financial Risk Management with Weather Hedges"] {{Webarchive|url=https://web.archive.org/web/20100127033259/http://riskbooks.com/Energy%20and%20Commodities/Climate-Risk-Weather-Market.php |date=2010-01-27 }}, Risk Books.
*Jewson, S., A. Brix and C. Ziehmann (2005). [https://books.google.com/books?id=IV8wh2zme5AC&pg=PP1 "Weather Derivatives Valuation: The Meteorological, Statistical, Financial and Mathematical Foundations"]. Cambridge, Cambridge University Press.
*Golden, L. L., M. Wang and C. C. Yang [http://www.actuaries.org/ASTIN/Colloquia/Manchester/Papers/brockett_paper_final.pdf "Handling Weather Related Risks Through the Financial Markets: Considerations of Credit Risk, Basis Risk, and Hedging."] Journal of Risk & Insurance, Vol. 74, No. 2, pp.&nbsp;319–346, June 2007.
*Myers, R. 2008 [https://web.archive.org/web/20130113221616/http://www.cmegroup.com/trading/weather/files/WeatherRisk_CEO.pdf "What Every CFO Needs to Know About Weather Risk Management"], Storm Exchange, Inc. & CME Group
*Mathews, J. S. (2009) [http://www.cmegroup.com/trading/weather/files/WT133_Weather_White_Paper_Final.pdf "Dog Days and Degree Days"], CME Group
*Tang, K., Ed. (2010). [http://riskbooks.com/Insurance/Weather%20Risk%20Management.php "Weather Risk Management: A guide for Corporations, Hedge Funds and Investors"] {{Webarchive|url=https://web.archive.org/web/20100122004053/http://riskbooks.com/Insurance/Weather%20Risk%20Management.php |date=2010-01-22 }}, Risk Books.

==See also==
*Weather Risk Management
*MSI GuaranteedWeather, LLC
*[[Company:The Climate Corporation|The Climate Corporation]]
*[[Finance:Alternative risk transfer|Alternative risk transfer]]
*[[Physics:Fixed bill|Fixed bill]]
*CelsiusPro

==References==
<references />

==External links==
* [https://www.weatherxchange.com/ weatherXchange – the independent platform which helps companies access index-based weather risk protection ]
* [http://www.speedwellweather.com/Pages/Others/Marketing/SWS.aspx Speedwell Weather for weather risk management software]
* [http://www.speedwellweather.com Speedwell Weather for independent weather risk hedging]
* [http://www.climetrix.com CLIMETRIX: Third party pricing and portfolio risk management system for Weather Derivatives traders]
* [http://www.yjenergy.com YellowJacket OTC Weather Derivative Trading and Network]
* [http://www.cmegroup.com/trading/weather/index.html Main CME weather page]
* [http://www.wrma.org/wrma/index.php?option=com_content&task=view&id=36&Itemid=34 Weather Risk Management Association]
* [http://www.ft.com/cms/s/193150ea-f1ce-11db-b5b6-000b5df10621.html UBS Launches First Global Warming Index "UBS-GWI"]
* [http://www.consus.eu/_en Consus, Emission trading]
* [http://www.celsiuspro.com/ CelsiusPro, Professional Weather Protection]
* [http://www.linkedin.com/groups?gid=64408 Weather Derivatives and Weather Risk Professionals Group]
* [http://www.artemis.bm Weather risk management and risk transfer news and research from Artemis.bm]
* [http://www.meteologica.com Weather forecasts for derivatives trading]


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