Weather derivatives - how to make money on degrees?
Even in our high-tech society, we are still greatly influenced by the weather. It determines what we wear outside today and whether we go on a picnic. Not surprisingly, weather conditions also have a significant impact on the profits of companies in many industries: construction stops when it's cold, energy companies lose money when it's a warm winter, and amusement parks lose money when it's a cold summer.
American researchers estimate that revenues of about 20% of the U.S. economy are directly dependent on weather conditions. So that companies can somehow protect profits from the vagaries of nature, there are insurances. But they can only protect against abrupt and significant changes in weather conditions, which occur very rarely. What companies need is a more flexible mechanism that would allow them to cover losses even in the event of normal changes in temperature. Mechanisms of this type are weather derivatives.
Definition of weather derivatives
Weather derivatives - are financial contracts whose payments are directly dependent on weather conditions. It is this relationship to the weather that allows them to be used to protect company profits from adverse environmental conditions.
It is worth mentioning that payments on any derivatives depend on the value of some asset (e.g., a stock). Weather contracts - is no exception, but the asset in this case is less obvious. If we make contracts based on the weather, then we need to "measure" the weather somehow. The simplest and most common gauge in this case is temperature. However, there are contracts that are made for rainfall and even wind speed.
Principles of Weather Derivatives
We build a weather index.
As previously mentioned, one of the indicators for measuring the weather is temperature. In practice, not just thermometer readings are used, but CDD (Cooling Degree Day) weather indices и HDD (Heating Degree Day). The first is used in the warmer months of the year, the second in the colder months.
CDD Weather Index is calculated as the number of degrees by which the average daily temperature is greater than 18 ° C. That is, CDD = the average temperature minus 18 ° C. If the average temperature is less than 18 ° C, the CDD is taken as 0. For example, if the average temperature for the day is 28 ° C, then CDD = 28 - 18 = 10. Similarly calculated and HDD weather index, the difference is that it is counted as the number of degrees by which the average temperature is less than 18 ° C.
It is worth noting that for many companies it does not make much sense to sign a contract for a specific day, it is more convenient to sign it at once for a longer period of time. For example, an energy company does not care what the temperature will be on a particular day, but it is more important what it will be for a certain period of time. In this case, the indices for the whole period will be used, which are calculated as the sum of the daily indices.
We calculate the payments on the weather forward.
Let's see in a simplified situation how the simplest one works weather derivative - forward. To conclude forward two parties are needed. In our case, it will be a road builder and an ice cream maker who want to contract for the temperature expected tomorrow. In case tomorrow will be very hot, the builder will not be able to build roads and will incur a loss of $500, the ice cream maker, on the contrary, will be able to sell more ice cream and make a super profit of $1500. In case tomorrow will be cooler than usually, the ice cream maker will not sell as much ice cream as he planned and will incur a loss of $200, while the builder, on the contrary, will build everything in time and even in larger quantities, making a super profit of $2000. To get rid of the weather risks, they can conclude forward contract on the temperature that will be tomorrow.
Suppose they have agreed that the contract temperature is 28 °C (=10 CDD), and the contract value is $100. This means that if the temperature is above 28 °C, the ice cream maker will pay $100 for each "extra" degree, and if the temperature is less than 28 °C, then the builder will pay the ice cream maker $100 for each degree below. Thus, if tomorrow is very hot, e.g. 35°C, then the ice cream maker will sell more ice cream than usual and make a super profit, but he will have to pay $700 (=(35-28) ? 100) to the builder. The latter, although he will suffer a loss because of his inability to work in the heat, will receive $700 from the ice cream man. If the temperature drops below 28 ° C, for example to 23 ° C, in this situation, the ice cream maker will suffer losses, but will receive payments on the contract value of $500, and the builder will build more roads and get a super profit, but part of it will have to pay the ice cream maker. In the end, it turns out that whatever the weather tomorrow, each of our actors will be "insured" in case of failure and always remain at least in a small, but profitable position. Indeed, they will not be able to make more profit, but they will not be left with losses either (see Table 1).
Weather derivatives in Russia
Marketplace weather derivatives is widely developed in the United States. According to the audit and consulting company PricewaterhouseCoopers, the total volume of transactions in this market in 2006 amounted to more than 40 billion dollars. These are big volumes for a market that is just over 9 years old. How are things in Russia? The reality is that we have a market weather derivatives does not exist. However, according to the RTS Stock Exchange, such contracts are being developed, and their release is planned for this year.