sigizmund October 23, 2009 at 14:30

Weather Derivatives

Now that some Khabrovsk residents have mastered carrot derivatives, we can move on to more complex and much more real weather derivatives. The use of weather forwards may seem incredible, but the market for these tools does not just exist, its volume in the United States exceeds $ 40 billion.

Attention: the post was written by the doz habrayuzer - address him all the pluses in karma, which was not enough to post on a thematic blog.

Update:The post was read by my wife, who is engaged in finance and also makes masters in this specialty. She said that “weather derivatives” is just an extremely special case, and if you understand how derivatives work in general, you can do them for anything, even for Her Majesty the Queen’s health, even for the rainfall in Rio de Janeiro, the main thing - for someone to need it. One day I'll try to get her to write a post here ... (your sigizmund ).

What are weather derivatives?

Even in our high-tech society, we are still very exposed to the weather. It depends on her in what we will go out today and go on a picnic. It is not surprising that weather conditions also have a significant impact on the profits of companies in many industries: construction is stopped at low temperatures, energy companies suffer losses in the case of a warm winter, and amusement parks in the case of a cold summer. American researchers estimate that incomes of about 20% of the US economy are directly dependent on weather conditions. So that companies can somehow protect profits from the vagaries of nature, there are insurance. However, they can protect only from a sharp and significant change in weather conditions that occur extremely rarely. Companies need a more flexible mechanism, which will cover losses in the event of normal temperature changes. Mechanisms of this type have become weather derivatives.

Definition

Weather derivatives are financial contracts for which payments directly depend on weather conditions. It is this relationship with the weather that allows them to be used to protect the company's profits from adverse environmental conditions. It is worth saying that payments on any derivatives depend on the value of some asset (for example, shares). Weather contracts are no exception, but the asset in this case is less obvious. If we conclude contracts based on the weather, then we need to somehow "measure" the weather. The simplest and most common meter in this case is temperature. However, there are contracts that are concluded for rainfall and even wind speed.

How weather contracts work

Building a weather index

As mentioned earlier, one of the indicators for measuring weather is temperature. In practice, not just the thermometer readings are used, but the weather indices CDD (Cooling Degree Day) and HDD (Heating Degree Day). The first is used in the warm months of the year, the second - in the cold. CDD is calculated as the number of degrees by which the average daily temperature is more than 18 ° C. That is, CDD = average temperature minus 18 ° C. If the average temperature is less than 18 ° C, then the CDD is assumed to be 0. For example, if the average temperature for the day is 28 ° C, then CDD = 28 - 18 = 10. The HDD is calculated in a similar way, the difference is that it is considered as the number of degrees by which the average temperature is less than 18 ° C. It is worth noting that for many companies it makes little sense to conclude a contract for a specific day, it is more convenient to conclude it immediately for a longer period. For example, the energy company does not matter what the temperature will be on a particular day, but more importantly what it will be for a certain period of time. In this case, indices for the whole period, which are calculated as the sum of daily indices, will be used.

We calculate weather forward payments

Let's see in a simplified situation how the simplest weather derivative, the forward, works. To conclude a forward two sides are necessary. In our case, it will be a road builder and ice cream maker who want to conclude a contract for the temperature expected tomorrow. If tomorrow is very hot, the builder will not be able to build roads and suffer losses in the amount of $ 500, while the ice cream maker, on the contrary, will be able to sell more ice cream and get superprofits of $ 1,500. If tomorrow is cooler than usual, the ice cream maker will not sell as much ice cream as he planned, and will incur losses of $ 200, and the builder, on the contrary, will build everything on time and even in large volumes, earning an excess profit of $ 2000. To get rid of weather risks, they can sign a forward contract for the temperature that will be tomorrow. Suppose they agreed that the temperature of the contract is 28 ° C (= 10 CDD), and the size of the contract is $ 100. This means that at temperatures above 28 ° C the ice cream maker will pay $ 100 for each “extra” degree, if the temperature is less than 28 ° C, then the builder will pay the ice cream maker $ 100 for each degree lower. Thus, if tomorrow it will be very hot, for example, 35 ° C, then the ice cream maker will sell more ice cream than usual and get superprofits, but he will have to pay $ 700 (= (35-28) × 100) to the builder. The latter, although it will incur losses due to the inability to work in the heat, will receive $ 700 from the ice cream maker. If the temperature drops below 28 ° C, for example, to 23 ° C, then in this situation the ice cream maker will suffer losses, however, he will receive payments under a contract of $ 500, and the builder will build more roads and get extra profit, however, part of it will have to be paid to the ice cream maker. Ultimately, it turns out that no matter what the weather happens tomorrow, each of our characters will be “insured” in case of failure and will always remain at least in a small, but plus. Indeed, they will not be able to receive excess profits, but they will not remain in loss (see Table 1).