Magazine article Risk Management

The Weather (Derivatives) Report. (End Analysis)

Magazine article Risk Management

The Weather (Derivatives) Report. (End Analysis)

Article excerpt

Weather derivatives have come a long way since 1997 when a handful of American energy companies developed several dozen over-the-counter (OTC) contracts. Weather derivatives are traded on the Chicago Mercantile Exchange (CME), the London International Financial Futures Exchange and the Helsinki Exchanges, with futures and options exchanges in other countries also seriously considering this innovation.

Although the notional value of contracts written in the past year was down $1 million from the previous year, from April 2002 through March 2003, the number of contracts transacted worldwide nearly tripled according to the Weather Risk Management Association. This amounts to 11,756 contracts with a value of nearly $4.2 billion.

Originally targeted toward utilities to enable them to hedge against unseasonable weather, these derivatives are now used by farmers, resorts, casinos, the travel industry, manufacturers of seasonal equipment, underwriters, reinsurers and any other sector with revenues subject to the vagaries of the weather.

Prior to the development of weather derivatives, businesses were unable to hedge against overall weather conditions. Some micro hedges existed, such as weather insurance (event insurance) and agricultural futures, but these are narrowly focused. Weather insurance hedges a narrow window of time, often one day. Agricultural futures hedge a tiny sector of the economy, such as soybeans. These micro hedges, even when aggregated, do not allow businesses to hedge against the risk of pervasively adverse weather conditions.

The impetus for the development of weather derivatives was the extremely warm winter of 1997 through 1998, when El Nino depressed the revenues of many utilities. An OTC market for weather options quickly emerged, but it proved ineffective due to lack of liquidity, an absence of price transparency and the ever-present risk of counterparty default.

This embryonic OTC market for weather derivatives languished until 2001 when the Chicago Mercantile Exchange introduced exchange-traded weather derivatives (both futures and options) which created the liquidity, price transparency and counterparty certainty that the market needed to be viable. …

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