Weather Derivatives and Weather Risk Management

Article excerpt

ABSTRACT

Weather derivatives are a relatively recent kind of financial product developed to manage weather risks, and currently the weather derivatives market is the fastest-growing derivative market. The development of weather derivatives represents one of the recent trends toward the convergence of insurance and finance. This article presents an overview of weather risks, weather derivatives, and the weather derivatives market, and examines the valuation of weather derivatives in an incomplete market, the hedging effectiveness of standardized weather derivatives, as well as optimal weather hedging with the consideration of basis risk and credit risk.

INTRODUCTION

Weather derivatives, which first emerged in the United States in 1997 following the deregulation of American energy and power industries, represent a recent type of financial product developed to hedge weather risks. Global businesses are considerably exposed to increasingly uncertain global weather conditions. Besides energy and power industries, agriculture, insurance, tourism, and retail businesses are also directly or indirectly affected by weather (see, for example, Dischel, 1998; Zeng, 2000). Weather derivatives enable those businesses that are adversely affected by unanticipated weather swings to manage this risk, in the same way that hedgers regularly use traditional financial derivatives to hedge their risks in interest rates, equities, and foreign exchange.

According to the Chicago Mercantile Exchange (CME), the weather derivatives market is the fastest-growing derivative market today.1 However, there are few studies that discuss the key factors affecting the development of this evolving market. This article aims to fill this gap in the literature. Specifically, the article presents an overview of weather risks, weather derivatives, and the weather derivatives market, and then examines the valuation issue of weather derivatives in the incomplete market, the hedging effectiveness of standardized weather derivatives, as well as optimal weather hedging with consideration of basis risk and credit risk.

The article is structured as follows: The second section introduces weather risks and weather derivatives. The next section presents the development of the weather derivatives market. This is followed by sections investigating and summarizing current research on weather derivatives and weather hedging, and the last section concludes with a short summary and some ideas for future work.

WEATHER RISKS AND WEATHER DERIVATIVES

Weather risks are the uncertainty in cash flows and earnings caused by noncatastrophic weather events such as temperature, humidity, rainfall, snowfall, stream flow, and wind. They are contrasted with the catastrophe-related risks (CAT risks) caused by hurricanes, tornadoes, and windstorms, among others. Weather risks have an enormous impact on business activities of many kinds. The U.S. Department of Commerce estimates that nearly one third of the U.S. economy is directly affected by the weather.2 An article in the Neiv York Times (June 27, 1999) reports that American companies with significant exposures to weather risks have more than $1 trillion in yearly revenues. Similarly, an estimated $1.25 trillion of the European economy and $700 billion of the Japanese economy are exposed to weather risks. A sample of weather risks faced by various industries is given in Table 1.

Weather exposure can be defined as dR/dW, i.e., the sensitivity of revenue (or cost) to weather indexes. However, weather risk is primarily considered as a volume or quantity risk3 rather than a price risk. Although risk management tools for hedging price risks are widely available, such instruments have limited applicability for hedging volume risk. To hedge volume risks caused by weather events (weather risks), weather derivatives have been developed; they provide important complements to instruments that are better suited for hedging price risk. …