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					               WEATHER DERIVATIVES




                              BY

           Gaurav Patel(65)        Kishore Gulhane (74)
           Amit Mahajan ()         Chechnya ()




SAPM – Prof. Debankur                  ITM , Kharghar – Batch IV
    Presentation Flow

•   Evolution of Weather derivative
•   Global Implications
•   Definition & Anatomy
•   Techniques & Example
•   Weather derivatives Products Globally
•   Agriculture in India
•   Weather Market in India
WEATHER DERIVATIVES
                       Evolution
•   Weather derivatives are one of the fastest growing segments of the
    commodities market. These financial instruments are used by
    companies to hedge against the risk of weather-related losses.
•   The weather market traces its roots to deregulation of the U.S. energy
    industry.
•   Early pioneers in the market – energy traders Aquila, Enron, and Koch
    Industries – conceived of and executed the first weather derivative
    transactions in 1997.
•   The first deals were all arranged as privately-negotiated over-the-
    counter transactions and were structured as protection against warmer
    or cooler than average weather in specific regions for the winter or
    summer seasons.
•   As the market for these products grew, the Chicago Mercantile
    Exchange introduced the first exchange-traded weather futures
    contracts (and corresponding options), in 1999. The CME currently
    trades weather derivative contracts for 18 cities in the United States,
    nine in Europe, six in Canada and two in Japan.
                                 Global Implications




              Active & growing


              Emerging

The weather derivatives market has grown internationally. Weather transactions have been
completed in Countries such as the United States, United Kingdom, Australia France, Germany,
Norway, Sweden, Mexico and Japan. Exchange traded contracts in weather derivatives markets
are currently listed on the Chicago Mercantile Exchange {CME}, the Inter Continental Exchange
{ICE} the London International Financial Future and Options Exchange {LIFFE}.
Risk Holder         Weather Type          Risk
Energy Industry     Temperature           Lower sales during warm winters or
                                          cool summers
Energy Consumers    Temperature           Higher heating/cooling costs during
                                          cold winters and hot summers
Beverage            Temperature           Lower sales during cool summers
Producers
Building Material   Temperature/Snowfal   Lower sales during severe winters
Companies           l                     (construction sites shut down)
Construction        Temperature/Snowfal   Delays in meeting schedules during
Companies           l                     periods of poor weather
Ski Resorts         Snowfall              Lower revenue during winters with
                                          below-average snowfall
Agricultural        Temperature/Snowfal   Significant crop losses due to extreme
Industry            l                     temperatures or rainfall
Municipal           Snowfall              Higher snow removal costs during
Governments                               winters with above-average snowfall
Road Salt           Snowfall              Lower revenues during low snowfall
Companies                                 winters
Hydro-electric      Precipitation         Lower revenue during periods of
power generation                          drought
                       Definition
•   A financial weather derivative contract may be termed as a weather
    dependant contract whose payoff will be in an amount of cash
    determined by future weather events.
•   The settlement value of these weather events is determined from a
    weather index, expressed as values of a weather variable measured at a
    stated location.
•   Weather derivatives are financial instruments that can be used by
    organizations or individuals to reduce risk associated with adverse or
    unexpected weather conditions.
•    The difference from other derivatives is that the underlying asset
    (rain/temperature/snow) has no direct value to price the weather
    derivative.
•   The primary objective of weather derivatives is thus to hedge volume
    risks, rather than price risks, that result from a change in the demand
    for goods due to a change in the weather.
              Anatomy


•   Reference weather station
•   Index
•   Term
•   Structure
•   Premium
                        Techniques
•   The clear focus in dealing with weather derivatives is in the field of
    options designed to afford protection against fluctuating temperatures.

•   Options of this kind are based on so-called heating degree days (HDD)
    and cooling degree days (CDD). These indices represent the average
    temperature for a given period of time.

•   An HDD value equals the number of degrees the day's average
    temperature is lower than 65° F or in theory there typically would be no
    need for heating on a day warmer than 65°.

•   A CDD value equals the number of degrees an average daily
    temperature exceeds 65° F or in theory there typically would be no
    need for air conditioning if the temperature were less than 65°F.

•   For European cities, CME's weather futures for the HDD/CDD months
    are calculated according to how much the day's average temperature is
    lower/Above than 18° Celsius.
FORMULA :




• As a rule, HDDs measure the average temperature for the winter
  half-year(Nov 1 to Mar 31), while CDDs usually measure that for
  the summer half-year(May 1 to Sep 30)
•   While HDD options can be used to obtain protection against excessively
    warm winters, CDD options afford a safeguard against excessively cool
    summers.
•   The system for HDD/CDD calls n Puts is as follows




•   Tick Size : one tick corresponds to exactly one degree day. An amount
    (tick size) is defined per tick, this determining the level of the payout.
•   Strike Value : The strike value determines the amount (degree days)
    upwards of which the option can be exercised.
• Weather Swap :
    – A swap is a combination of put and call options, which have the
      same strike and are on the same underlying location. Revenue
      stability can be provided by degree day swaps.
    – An investor who is long the swap, will receive payments, if the
      recorded HDD or CDD are greater than the strike, and will make
      payments, if the recorded HDDs or CDDs are lower than the strike.


• Collars (Fences) :
    – A collar is a spread position that insulates the buyer from extreme
      movements in the underlying asset. It consists of purchasing an
      OTM call (or put) with a particular strike, and financing this with the
      sale of an OTM call (or put) with a different strike.


• Straddle :
    – A market player who does not expect any notable weather
      fluctuations can get himself twice the risk premium by way of a
      short straddle (simultaneous buying of a call and put option with
      the same strike value).
                            Example
•   Let us assume that a utility company operating primarily in Ohio wants
    to protect itself against a loss of turnover in the event of a slump in
    energy demand owing to an overly cool summer where little use is
    made of air-conditioning systems.
•   In this case, the utility company will buy a CDD put option for the
    summer half-year (long put).
•   the specifics of this option contract are to be as follows:




•   As per Strike value , the avg. temp over 180 days is 70.47 d ( 985 / 180 +
    65)
•   With the help of Option premium of 335,000 and tick size of $ 15000 ,
    the Break even (Xcdd) on basis of foll. Linear realtionship. :
•   15000 * (985 - Xcdd) – 335000 = 0
•   X ccd = 962.66
•   Now as per Break even pt. Xccd = 962.66 the avg. temp. comes to 70.34
    (962.66 / 180 + 65).

•   If the buyer is to obtain a positive result from this option, the average
    temperature during the 180-day period under review may not exceed a
    maximum of 70.34 °F. If the average temperature is above 70.34 °F, this
    option will be exercised by the buyer up to an average temperature of
    70.47 °F (amortization of the option premium). With an average
    temperature above 70.47 °F the option lapses and nevertheless entails
    expenditure of US$ 335,000.
•   Pay – off can be calculated as :

•   Pay-off = Min. (L – OP, TS* Max. [0,SV – CDD] – OP)
•   mit CDD = Σ(T(t) – 65) T(t) > 65
•   Where (L: limit, TS: tick size, SV: strike value, OP: option price)

•   If, for example, a total of 800 CDDs is determined over the 180-day
    period used as a basis
            here, the buyer of the above option achieves the following result:
            Min. (3,000,000 – 335,000, 15,000* Max. [0.987 – 800] – 335.00)
            = 15,000* (985 – 800) – 335,000 = 2,440,000
        Weather derivatives Product

• CME weather derivative product Globally
Agriculture in India

                • High dependence on weather
                    – Up to 80% of variability in
                      crop yields is attributable to
                      weather
                    – Less than 40% of net sown
                      area irrigated
                    – Most irrigation from non-
                      perennial sources
                    – Affects adoption of improved
                      crop production techniques
                      because of high risks and low
                      margins
                • Extreme Weather Events in India
                  (cold wave, drought, fog, heat
                  wave, tropical cyclones, floods)
                • Dwindling ground water
                  resources
Indian Weather Market – Customers
                                                                  5%




• Farmers
   – Risk of Crop Loss on Account of Weather
   – Impact of weather on dairy production                             95%


• Industries                                        Agriculture    Non-Agriculture


   – Production Risks – Agro/Marine Chemicals, Seed, Agro-
     Processing, Lime-kiln, Hydro Power etc
   – Market Risks – Agri-input, FMCG, Tractor etc.
• Banking
   – Covering exposure to both industries and farmer
   – Development loans like Rainwater Harvesting Projects
• Government
   – Subsidy Exposure on crop insurance
   – Developmental projects like Rainwater Harvesting Projects
Indian Weather Market : Issues
Data Deficiency
• Delayed Current Data
• Lack of quality Historical Data


Product Inefficiency                 Delayed Compensation
• Improper Risk Assessment
• Regulatory Restrictions
                                                                •Impacts
• Historical yield / production /                                Penetration
  sales data
                                                                 Levels
• Low Landholdings incase of         High Risk Transfer Cost
  agriculture                                                   •Inhibits Market
Inefficient Outreach                                             Development
• Weather Information
• Farm Management
• Inefficient Distribution          Lack of Product Knowledge
Customer / Risk Profile
• Large share of Rainfall Risk
• Single side Risks
• Major buyer segment is
  uneducated and ignorant about
  weather
Indian Weather Market: Opportunities

•   Agriculture Growth & Relevance to GDP
     – 60% population living in rural area
     – Primary rural occupation is agriculture
     – 65% agriculture is totally rain dependent
     – Weather dependent rural consumer demand
     – Agriculture reforms increasing outreach & induce corporate farming
•   Importance of Secondary Weather Market
     – Major agriculture commodity trading hubs
          • Mumbai, Kolkata, Jaipur & Indore
     – Weather trading a natural extension to commodities trading
     – Speculators and hedgers will provide liquidity for primary weather
        market
•   Growing Commodity Market
     – Fastest growing commodity market in the world
     – Large portfolio of agri-commodity
•   Power reforms
     – To correct demand supply mismatch in the sector
          What is Required to tap the
                  Potential?
• Long-term perspective – 5 years of infant-adolescence stage to
  address growth issues & creating trading market

• Legislative approval to allow trading on weather

• Knowledge and understanding of processes and systems in
  agriculture in India

• Understanding of weather systems operating in India

• Time and resources required in concept education and
  development at ground level

• Creation of infrastructure for data measurement &
  dissemination
Thank You
!! THANK YOU !!

				
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posted:8/6/2010
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