1. email address: yerodriguez@icesi.edu.co
Wind derivatives pricing issues
Yeny E. Rodríguez Ramos
Universidad Icesi, Cali, Colombia.
address:

2. Agenda 1. Introduction 2. Motivation 3. Objective 4
Agenda 1. Introduction 2. Motivation 3. Objective 4. Financial Derivatives 5. Weather Derivatives 6. Weather Derivatives Pricing 7. Conclusions

3. Introduction
El Niño is a recurrent climate event with unusual warm ocean temperature in the Equatorial Pacific.
The weather is being affected by the ENSO (El Niño Souther Oscillation), which influences temperature and precipitation across the globe.
What is El Niño? is a macro-scale weather anomaly that occurs when sea surface temperatures become unusually warmer-than normal across the central and east-central Equatorial Pacific Ocean. Warmer waters tend to have more evaporation. Where the extra precipitation comes down depends on the direction the winds blow. And El Niño shifts wind patterns, too
Source:

4. Colombia’s location on the map
The problem context
Colombia’s location on the map
Colombia heavily depends on water:
65% large hydropower plants
35% fossil-based technologies
<0,2% wind power
The system is vulnerable to droughts (El Niño)
More technology diversification is required
It is rich in renewable resources
Trade winds
Countries boarded by the central and eastern tropical Pacific Ocean suffer surface warming. Colombia is one of them. The big advantage is that is a country rich in renewable resources.

5. Motivation
- There is a clear need to diversify the portfolio of energy sources for the Colombian electricity sector; What would be the optimal mix of renewables to cope with the Colombian electricity demand of the next 15 years? - Literature on long term energy dispatch models that include renewables has been reviewed (Georgiou, 2016; Reddy & Bijwe, 2015; Sinha & Chandel, 2015; Guo, et al., 2012; Pranco & Salza, 2011; others) How incentivize the use of renewable resources in countries like Colombia? - Using Weather markets (Contreras & Rodríguez, 2014)
Colombia presents a clear need to diversify the portfolio of energy sources for the Colombian electricity sector, and may studies have focused on study the optimal mix of renewables to cope the Colombian electricity demand.
However, countries like this could be interested in to incentivize the use of sources like wind, taking into account the complementarity that exists between wind and precipitation.
Also, Contreras and Rodríguez (2016) propose to structure weather market in order to trade wind options, financial instrument which have a two-fold purpose, first, the end-user can recover the investment and, second, the end-user can hedge against the volatility of electricity prices in order to maximize their benefit.

6. Weather markets
Since their inception in 1996, weather derivatives have known a substantial growth. The weather market emerged by contracts developed by energy companies
Since its start, the weather market has expanded geographically, with weather business being transacted on risks from all inhabited continents, most particularly North America, Japan and Europe.
It is important to note that countries located in South America do not present any development in this topic, although can be affected by ENSO.

7. Weather markets Source: Alexandris & Zapranis (2013)
The categorization of the financial derivatives traded in the CME is presented. The weather derivatives market is organized as any other financial market. In September 1999, the Chicago Mercantile Exchange (CME) launched the first exchange-traded weather derivatives.
In the case of wind, CME has two underlying assets: Cumulative Wind Speed Index and Nordix Wind Speed Index
The main advantage of using wind indexes is that wind speed is often measured by a neutral third-party, generally a governmental agency in charge of collecting meteorological observations, which makes the index measurement independent and reliable.
Emerging from a period in which the market was dominated by energy business, the market is spreading to encompass a variety of sectors, including agriculture, construction, transportation and entertainment.
The weather market has emerged as an important contributor to the management of risk in a wide variety of businesses and areas of government responsibility.
Source: Alexandris & Zapranis (2013)

8. Objective To present alternatives to design and to price wind derivatives, using different methods that allow a comparison in terms of price and the derivatives characteristics
Under this perspective, the objective of this presentation is to present alternatives to design and to price wind derivatives, using different methods that allow a comparison in terms of price and the derivatives characteristics.

9. Weather Derivatives: Definition
In general, derivative contracts generally represent a contract to trade a specified quantity of an underlying asset, at an agreed price and time. In particular, weather derivatives derive their value from climatic conditions such as temperature, snowfall, or wind.  Weather derivatives are of great economic importance in that they allow participants to manage a very specific form of risk. Wide variety of available structures - Swaps, Options, Collars, Exotic Options, etc.
Derivative contracts generally represent a contract to trade a specified quantity of an underlying asset, at an agreed price and time. In particular, Weather derivatives derive their value from climatic conditions such as wind, temperature.
Organizations are buying a type of insurance: the company assuming the risk will pay the purchaser a pre-set amount of money that will correspond to the loss or cost increase caused by the disruptive weather. As such, risk exposure can be managed in a wide range of settings.

10. Risk Management Products: Financial Options
A financial options gives the holder the right, but not the obligation, to buy (call) or sell (put) an underlying asset at a specific price on a specific date. Types: Put (sell) and Call (buy) Key concepts of Options: Strike Price (K): refers to the value at which the buyer of the option can sell the underlying asset, whose price at moment t is Pt Maturity: refers the moment in which is exercised the option. Prime: 𝑃𝑎𝑦𝑚𝑒𝑛𝑡 (𝜏 2 − 𝜏 1 ) =max(𝐾−𝑃 𝜏 2 ;0) Classification: American Option: can be exercised in any moment before at maturity, European Option: only are exercised at the moment of maturity of the option
A financial option gives the holder the right, but not the obligation, to buy (call) or sell (put) an underlying asset at a fixed price at some time in the future.
The buyer of a European call option pays an up-front premium and receives a payout if the value of the relevant index exceeds the strike price, D, at the maturity of the option.

11. Risk Management Products: Weather Options
Key concepts of Options: Underlying index (𝑁 𝜏 1 , 𝜏 2 ) : refers to underlying index, for example Nordix index Strike index (K): refers to the index value at which the buyer of the option can sell the underlying index. Tick Size: refers to the monetary value of one point of the index, Tick Value: 𝑇 (𝜏 2 − 𝜏 1 ) =max(𝐾− 𝑁 𝜏 1 , 𝜏 2 ;0) Prime: 𝑃𝑎𝑦𝑚𝑒𝑛𝑡 (𝜏 2 − 𝜏 1 ) =Tick Size∗Tick Value
𝑁(𝜏 1 , 𝜏 2 )=100+ 𝑡= 𝜏 1 𝜏 2 𝑊 𝑡 − 𝑤 20 𝑡
A financial option gives the holder the right, but not the obligation, to buy (call) or sell (put) an underlying asset at a fixed price at some time in the future.
The underlying asset is NORDIX index, which is based on the deviations of the daily wind speed from a 20-year mean value.

12. Risk Management Products: Barrier Weather Options
Barrier options are cheaper than traditional because payment includes zeroes. Key Additional concepts: Barrier of option (Nb): refers the level at which the option is enabled or disabled depending on its purposes. Tick Value: T= 𝑁 𝜏 1 , 𝜏 2 > 𝑁 𝑏 ; 𝑇=𝑀𝑎𝑥 ( 𝐾−𝑁 𝜏 1 , 𝜏 2 ,0) 𝑁 𝜏 1 , 𝜏 2 ≤ 𝑁 𝑏 ; Types: Up (Down) and out: the underlying fluctuates under (over) the barrier and if the option reaches (crosses) then the option ceases to exist (knock-out). Up (Down) and In: the underlying fluctuates under (over) the barrier and if the option reaches (crosses) then the option takes a value.
There exist an exotic type of options: Barrier options. The main characteristic of this options is that are cheaper than tradional options, because are limited in some values.

13. Traditional methods Derivatives Valuation
Black and Scholes (1973): Find a functional expression for pricing European call and put options under the following assumptions: Prices follow a normal distribution, continuous coverage exists, the interest rate is constant, and no arbitration Monte Carlo Simulation

14. Valuation methods of weather Derivatives
Monte Carlo Simulation is the most used. The Black-Scholes method becomes irrelevant because: 1) The major indexes weather do not follow normal distributions (Meisser & Burke, 2009) , 2) the underlying variables are not tradable (Botos & Cimas, 2012) , ….

15. Application of Valuation methods Derivatives Climate
Clements, Hurn and Lindsay (2008) using the temperature index CDD (cooling degree day) to estimate the monetary payments of weather derivatives in 4 Australian cities from an AS-SGARCH model. Caporin, Pres and Toro (2012) energy value and temperature options for the city of Oslo from the HDD (heating degree day) series and using the Monte Carlo methodology. Karl Lopez and Wen (2015) work with CDD, HDD and CAT indices (daily average warming) and pose a neutral density function risk to value options traded on the CME with these indexes.
The majority of studies use indices for temperature.

16. Application of Valuation methods Derivatives Climate
Contreras and Rodríguez (2014) used an empirical simulation to evaluate wind put options in three stations of Colombia, and electricity prices are modeled using ARIMA-GARCH. Caporin and Pres (2009) use a ARFIMA-FIGARCH model to model and predict the speed, intensity and wind direction, and make an assessment of a financial derivative basis using a Monte Carlo simulation model. They use Cumulative Wind Speed Index. Working Paper Contreras and Rodríguez (2016) perform wind Put option pricing, taking into account the capacity, location and size of wind turbines in Colombia. They structured a contract option for 3 sizes of turbines, whose underlying asset is the Nordix.
The majority of studies use indices for temperature.

17. Application of Wind Barrier Options Valuation
Location: Almirante Station in Colombia Type of Contract: European Wind Put Option with up and in Barrier Underlying index: NORDIX index Strike index: was estimated with historical information of the index (Caporin and Pres, 2009) Pricing method: Monte Carlo Simulation Period: Summer
This is an european barrier put option. Until we know we did not find literature that price barrier options with climate indices

18. Wind Series: Almirante Station in Colombia

19. Wind Series: Simulation
WP Contreras & Rodríguez (2016) used ARIMA and ARFIMAS models to wind speed

20. Wind Put Option Valuation
Location: Almirante Station in Colombia
Period: January 1 – March 15
Capacity
Tick Size (USD/kWh per NORDIX)
225 MW
660 MW
1300 MW
Source: Working Paper Contreras & Rodríguez (2016)
Capacity
Wind Put Option Price (USD/kwh)
Barrier Wind Put Option Price (USD/kWh)
225 MW
0.0441
0.0303
660 MW
0.0542
0.0373
1300 MW
0.0581
0.0399

21. Comparison between Put Options Price and Wind Generation Cost
Although traditional option represents 71% of wind generation cost, and barrier option represents 49% of wind generation cost, both are the best alternative for the electricity market.

22. Comparison between Electricity Prices and Wind Generation Cost
Summer Period without El Niño
When comparing the price of the options With the price of electricity in Colombia during a summer period, it is observed that the price of a traditional option in some moments of the period is higher than the price of electricity, which is not profitable for the holder of, however, in the case of option barrier option price throughout the period it is always less than the price of electricity.

23. Comparison between Electricity Prices and Wind Generation Cost
Summer Period with El Niño
When comparing the price of the options With the price of electricity in Colombia during a summer period, it is observed that the price of a traditional option in some moments of the period is higher than the price of electricity, which is not profitable for the holder of, however, in the case of option barrier option price throughout the period it is always less than the price of electricity.

24. Comparison between Electricity Prices, Wind Generation Cost and Put Options Price
Summer Period with El Niño
The buyer of a European call option pays an up-front premium and receives a payout if the value of the relevant index exceeds the strike price, D, at the maturity of the option.

25. Conclusions
Structuring weather markets is useful for countries interested in defining policy measures in order to promote the use of renewable energy sources,
Weather derivatives are used to manage the impact of weather risk events with a high probability of occurrence,
In particular, wind power generators, whose profits and revenues could be affected by weather risks, can invest in the weather derivatives market and have the right to sell their energy at the cost of generation, making the recovery of their investments possible, and hedging their cash flows against the risks associated with the variability of wind speed.

26. Thanks for your attention