Are You Covered? Just as Professionals Use Futures and Options to Hedge Their Risk in Interest Rates, Equities and Foreign Exchange, Businesses Can Now Manage Their Economic Exposure to Fluctuations in the Weather

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A change in the weather can have a significant impact on a company's bottom line. The agriculture, apparel, beverages, construction, energy, entertainment, gaming, production, promotions, retail, sports and transportation sectors are all clearly sensitive to the weather. Deutsche Bank has estimated that four-fifths of all economic activity worldwide is directly or indirectly affected by the weather. The US Department of Commerce says that at least $1trn of the US economy is weather-dependent.

In 2005, investment bank ABN Amro produced the first study aimed at quantifying the extent to which adverse weather conditions affect industry production in Europe and the US. The report assigns weather risk ratings based on industry-wide weather-related losses for the period 1980-2003. The results show the vast amount of production that is vulnerable to the weather. More than half of the US receives the worst possible rating, indicating weather exposure of more than 35 per cent of overall production. No American state is assigned an exposure lower than 20 per cent. In Europe, the United Kingdom, Portugal, Sweden, Denmark and Holland obtain the worst ratings. Spain, Italy, Belgium and Austria have 25-30 per cent of their production exposed to weather, and Germany's and France's sensitivity is more than 20 per cent.

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The weather derivatives market enables those businesses that could be adversely affected by unanticipated weather to transfer this risk. Just as professionals regularly use futures and options to hedge their risk in interest rates, equities and foreign exchange, now there are tools available for the management of risk from extreme movements of nature. Weather derivatives are needed because so much economic activity and the fate of so many different businesses depends on weather conditions.

While energy and utility companies have led the way in weather risk management, and to this day continue to be the leading players, many other different types of businesses have also appreciated the financial benefits of hedging their weather exposure. As noted, the number of potential end-users of weather derivatives is vast. For instance, a sports drink manufacturer might wish to minimise the impact of weather on sugar prices, its largest input cost. A derivatives structure could be designed so that it hedges the company against weather that is detrimental to the sugar industry. Similarly, an ice-cream maker may want to manage its exposure to a cool summer that limits sales. It could enter into a contract that would pay out if the temperature for the July/August period fell below a certain threshold. A hotel operator could stand to lose financially were the amount of rain to be heavier than expected. In this case, a derivative could be devised that hedges such precipitation risk. There are countless other examples involving ski resorts, shipbuilders, fruit growers, golf clubs and restaurants.

The number of possible applications (and thus value-adding capabilities) of weather derivatives has been dramatically enhanced in recent years. The first member of the weather derivatives family to appear on the scene was the so-called "temperature contract". Temperature derivatives are still by far the most widely used type of weather derivative, accounting for around 90 per cent of the total mar- ket, but other, younger members of the weather family are making significant strides, in a clear sign that the market is evolving. Contracts relating to the level of rainfall, the speed of wind, the amount of snow, the frequency of typhoons, the height of waves or the level of humidity have been negotiated at one point or another. Some people are even suggesting the need for solar and space derivatives.

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Another key development that makes weather derivatives more attractive and user-friendly has been the introduction of exchange-traded products. …