FINANCIAL DERIVATIVES/SNSCT/MBA Weather Derivatives Weather derivatives are financial instruments that can be used by organizations or individuals as part of a risk management strategy to reduce risk associated with adverse or unexpectedweather conditions. ... Settlement is objective, based on the final value of the chosen weather index over the chosen period. FINANCIAL DERIVATIVES/SNSCT/MBA

FINANCIAL DERIVATIVES/SNSCT/MBA Even in our advanced, technology-based society, we still live largely at the mercy of the weather. It influences our daily lives and choices, and has an enormous impact on corporate revenues and earnings. Until recently, there were very few financial tools offering companies' protection against weather-related risks. However, the inception of the weather derivative - by making weather a tradeable commodity - has changed all this. Here we look at how the weather derivative was created, how it differs from insurance and how it works as a financial instrument. FINANCIAL DERIVATIVES/SNSCT/MBA

Weather: Risky Business It is estimated that nearly 20% of the U.S. economy is directly affected by the weather, and that the profitability and revenues of virtually every industry - agriculture, energy, entertainment, construction, travel and others - depend to a great extent on the vagaries of temperature. In a 1998 testimony to Congress, former commerce secretary William Daley stated, "Weather is not just an environmental issue; it is a major economic factor. At least $1 trillion of our economy is weather-sensitive." FINANCIAL DERIVATIVES/SNSCT/MBA

FINANCIAL DERIVATIVES/SNSCT/MBA he risks businesses face due to weather are somewhat unique. Weather conditions tend to affect volume and usage more than they directly affect price. An exceptionally warm winter, for example, can leave utility and energy companies with excess supplies of oil or natural gas (because people need less to heat their homes). Or, an exceptionally cold summer can leave hotel and airline seats empty. Although the prices may change somewhat as a consequence of unusually high or low demand, price adjustments don't necessarily compensate for lost revenues resulting from unseasonable temperatures. Finally, weather risk is also unique in that it is highly localized, cannot be controlled and despite great advances in meteorological science, still cannot be predicted precisely and consistently. FINANCIAL DERIVATIVES/SNSCT/MBA

Temperature as a Commodity Until recently, insurance has been the main tool used by companies' for protection against unexpected weather conditions. But insurance provides protection only against catastrophic damage. Insurance does nothing to protect against the reduced demand that businesses experience as a result of weather that is warmer or colder than expected. In the late 1990s, people began to realize that if they quantified and indexed weather in terms of monthly or seasonal average temperatures, and attached a dollar amount to each index value, they could in a sense "package" and trade weather. In fact, this sort of trading would be comparable to trading the varying values of stock indices, currencies, interest rates and agricultural commodities. The concept of weather as a tradeable commodity, therefore, began to take shape. "In contrast to the various outlooks provided by government and independent forecasts, weather derivatives trading gave market participants a quantifiable view of those outlooks," noted Agbeli Ameko, managing partner of energy and forecasting firm EnerCast. In 1997 the first over-the-counter (OTC) weather derivative trade took place, and the field of weather risk management was born. According to Valerie Cooper, former executive director of the Weather Risk Management Association, an $8 billion weather-derivatives industry developed within a few years of its inception. FINANCIAL DERIVATIVES/SNSCT/MBA

In Contrast to Weather Insurance In general, weather derivatives cover low-risk, high-probability events. Weather insurance, on the other hand, typically covers high-risk, low-probability events, as defined in a highly tailored, or customized, policy. For example, a company might use a weather derivative to hedge against a winter that forecasters think will be 5° F warmer than the historical average (a low-risk, high-probability event). In this case, the company knows its revenues would be affected by that kind of weather. But the same company would most likely purchase an insurance policy for protection against damages caused by a flood or hurricane (high-risk, low-probability events) FINANCIAL DERIVATIVES/SNSCT/MBA

CME Weather Futures and Options on Futures In 1999, the Chicago Mercantile Exchange (CME) took weather derivatives a step further and introduced exchange-traded weather futures and options on futures - the first products of their kind. OTC weather derivatives are privately negotiated, individualized agreements made between two parties. But CME weather futures and options on futures are standardized contracts traded publicly on the open market in an electronic auction-like environment, with continuous negotiation of prices and complete price transparency. Broadly speaking, CME weather futures and options on futures are exchange-traded derivatives that - by means of specific indexes - reflect monthly and seasonal average temperatures of 15 U.S. and five European cities. These derivatives are legally binding agreements made between two parties, and settled in cash. Each contract is based on the final monthly or seasonal index value that is determined by Earth Satellite (EarthSat) Corp, an international firm that specializes in geographic information technologies. Other European weather firms determine values for the European contracts. EarthSat works with temperature data provided by the National Climate Data Center (NCDC), and the data it provides is used widely throughout the over-the-counter weather derivatives industry as well as by CME FINANCIAL DERIVATIVES/SNSCT/MBA

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