Weather derivative
A weather derivative is a derivative financial instrument in which meteorological data such as B. the temperature or the amount of precipitation can be used as a base value . Weather derivatives are usually concluded between a bank or insurance company and a contractual partner (company, municipality), with the company transferring its weather risk to the bank. Since according to estimates by economists around four fifths of all economic activities worldwide are directly or indirectly influenced by weather, weather derivatives can represent a risk management tool for a company . The weather derivatives, which were only developed towards the end of the 1990s, are, however, still a relatively young instrument on the financial market, which, in contrast to other hedging instruments, for example for interest rate or exchange rate risks, are not standardized. Weather futures as a standardized product have so far only been traded to a very small extent on Eurex , the Chicago Mercantile Exchange and LIFFE in London .
Example of risk transfer through a weather derivative
With the following - constructed - example, the functionality and possible uses of weather derivatives can be easily explained:
A farmer who grows peaches in Central Europe depends on the fact that the temperature never falls below a certain temperature during the flowering period of the frost-sensitive trees. The longer the temperature is below 5 ° C , the lower its harvest volume. This farmer can transfer his business risk to a bank by concluding a corresponding weather derivative with the provider. The contract could be designed in such a way that the farmer receives a compensation amount of 1,000 for every day in April and May - the months in which the frost-sensitive peach trees are in bloom - when the temperature measured by the nearest weather station falls below 5 ° C Receives euros . Whether he pays an option premium for this contract , or whether he has a payment obligation to the bank if the temperature is above five degrees Celsius, depends on which specific hedging instrument is chosen.
The hedging instruments
Special feature of weather derivatives compared to other derivative financial products
The construction of the instruments used for weather derivatives is essentially the same as the standard derivative hedging transactions used in financial management . However, weather derivatives have a special feature: the objects to which they refer (referred to as base values in technical terms ), namely daytime temperatures, snow depth , amounts of precipitation or the like, are not tradable. This has some consequences in corporate practice and in the use of this instrument in financial mathematics . The volatility of the weather derivatives is derived solely from the historical weather data. There is no market price volatility in the classic sense, as is the case with hedging instruments for stocks or currencies . In contrast to stocks or commodities such as silver , the base value cannot be influenced by individual market participants either, for example by selling large quantities of them at certain times or by speculating on price increases. The base value of weather derivatives can therefore be regarded as free from market manipulation .
In contrast to other derivative hedging instruments, physical delivery on the due date is excluded with the weather derivative . Would the farmer who grows peaches, its expected autumn harvest in the spring on futures selling, he might his opponent the agreed amount on the due date of its fixed-price transaction actually deliver. Such forward transactions - which are actually concluded on commodity futures exchanges like the one in Chicago - are, however, usually offset by compensation payments. In the case of weather derivatives, however , this so-called cash settlement is the only way to end the transaction.
The pricing of weather derivatives is still problematic. The Black-Scholes model , which is otherwise used as standard for pricing, does not fit this instrument. A Monte Carlo simulation , which can be used as an alternative, is very complex to use. While banks can usually still map this due to their software equipment, this poses a problem in particular for companies that have to be able to independently evaluate financial derivatives that have been concluded due to internal company regulations. For these companies, trades in weather derivatives would be associated with a complex upgrade of their treasury systems .
Underlying values of weather derivatives
Weather derivatives can reference a very large number of different base values, as there are a multitude of ways to quantify weather. To hedge against business risks, however, the corresponding weather derivative must refer to the correct base value in order to represent a meaningful hedge. In the above example of the peach-growing farmer, the average daily temperature in Germany or Austria is irrelevant - what matters to him is what temperature is measured near his peach plantation. For a municipality that wants to protect itself against excessive snow removal costs, it would not be the snowfall on the Zugspitze that would be decisive, but the one measured on site.
Temperature is the most common measure of weather. According to a study by the Weather Risk Management Association , 95% of all concluded weather derivatives had temperature values as a base value in 2002 . Other base values are the wind speed , snowfall and rain , water level, cloud cover , sunshine duration or the relative humidity . For snowfall and rain i. d. Usually, once a day, the amount of precipitation measured in the last 24 hours is measured in millimeters.
The exemplary farmer who wants to ensure the temperature dependence of his peach harvest will find it difficult to find a weather station that is so close to his plantation that it correctly reflects the temperature that is essential for him. For him, however, there is the possibility of combining the values of several weather stations in such a way that the probability increases that this will indicate the temperature that is relevant for him. Other companies with a different risk structure than the exemplary farmer enter into longer-term contracts, as this is more likely to ensure that they receive a payment from the weather derivative they have concluded that corresponds to their entrepreneurial risk.
Hedging instruments
In terms of terminology, structure and settlement practice, weather derivatives correspond to the usual financial derivatives. Options and futures are the usual forms of transactions that are used here. Options, in particular, are typical instruments that, according to estimates by market participants, account for around 70 to 80% of deals. As with the hedging of exchange rate and interest rate risks, a number of option structures are conceivable, which can be very differentiated according to the risk profile.
Forward deal
A forward transaction - in this context often referred to as a swap in technical terms - is the easiest to understand instrument in the context of weather derivatives. There is no premium payment here; instead, the bank and the company exchange weather risks. For the peach-growing farmer, this would mean an agreement with his bank, under which he would receive a payment of 1,000 euros for every day on which the temperature drops below five degrees Celsius in April and May . Conversely, with this type of transaction, the farmer has to pay the bank 1,000 euros for every day the temperature is above five degrees Celsius. The maximum payout amount for both counterparties would be 61,000 euros with this contract. Before signing this contract, however, the farmer must decide whether this construction corresponds to his risk profile at all. This analysis includes, among other things, the question of whether he really only loses 1,000 euros in harvest if the temperature falls to, for example, −3 ° C during this period and the entire blossom of the trees is destroyed. Conversely, he has to ask himself whether every day when the temperature is above five degrees Celsius he will really have an additional amount of harvest in autumn that corresponds to the 1,000 euros that he then has to pay to the bank.
The example of a producer of ice cream , however, shows that a forward contract can be constructed so that it meets an established risk structure. Based on previous analyzes, this producer knows that with every additional degree Celsius, which means that the average temperature in June, July and August is below 20 degrees, he loses a million euros in sales and thus 100,000 euros in profit. With every additional degree Celsius at which the average temperature is above 25 degrees Celsius, on the other hand, he converts one million euros more ice cream. He wants to compensate for these fluctuations in sales volume by concluding a corresponding forward deal. Accordingly, he concludes a forward deal with his bank that compensates for the collapse in profits that comes with the slump in sales and which he suffers in an unusually cold summer. He is prepared to give up the profit he would have in an unusually hot summer.
Options
Options are the most common form of hedging against weather risk. Here mean put options to bet on falling and purchase options a bet on rising indices. In any case, a premium is required for the option. The option, however, means hedging the weather risk while preserving the profit potential of a company.
Both the ice cream manufacturer and the peach-growing farmer want to protect themselves against the business risks that falling temperatures pose for them. Both would therefore buy a put option. The peach-growing farmer has decided that it suits his risk structure better if he receives a payment of 100 euros for every degree below a daily temperature of 5 degrees Celsius measured in April and May.
Purchase options, on the other hand, are acquired by those for whom rising weather indices pose a risk. Their application is shown in a contract concluded in 2001 for a rural power station in Lower Saxony . The analysis of several years at this company had shown that the electricity turnover in the summer months was partly dependent on how often farmers turned on their irrigation systems . Very rainy summers could mean a drop in annual profits of up to 20 percent for this company. The company therefore bought a call option, the payout amount depending on the rainfall. The contract had a term from May 1 to August 31, 2001 and the base value was the amount of precipitation measured in millimeters from a nearby weather station. The so-called exercise price of the contract was 70 millimeters of rainfall, as analyzes showed that the average rainfall was 65 millimeters. This means that the company was willing to bear the decline in profits, which was associated with rainfall between 65 and 70 millimeters. The company wanted to protect itself against the slump in profits that went hand in hand with higher amounts of precipitation. The company therefore agreed a payment of DM 2,000 for every millimeter of precipitation greater than 70 millimeters . The company paid a little less than DM 10,000 as the option premium. A maximum payment amount was contractually agreed, although this amount has remained unknown.
Market participants
Entrepreneur
Although farmers and municipalities have been tried on various occasions as opponents of a weather derivative in this article, they have so far not been the typical participants in the market for weather derivatives. The pioneers in the market for weather derivatives were US energy suppliers , where the daily amount of energy consumed strongly correlates with the current daily average temperature . However, the experience of these companies also shows how complex the risk-adequate construction of a weather derivative is. Energy consumption and daytime temperature are not linearly correlated , but a very differentiated distinction must be made between those days on which energy consumption increases because households are heating, and those on which more energy is consumed because they switch on their air conditioning systems .
In addition to energy suppliers, it is primarily insurers and reinsurers for whom weather derivatives are interesting as a hedging instrument.
In general, companies that are considering the use of weather derivatives or have already completed one already have experience with the use of derivative instruments to hedge financial risks. You are therefore familiar with the risk management process , the first step of which is to carefully analyze your own risk structure. They also have the necessary organizational structure to which a so-called front office , a settlement ( back office ) and generally also a financial risk control matters.
The banks
Banks occasionally enter into weather derivatives also because they actually want to hedge against a weather risk that they have due to their business activities. Your motivation then corresponds to the risk-hedging companies described here.
In this article they are described as the counterparty to whom a company transfers its risk by entering into a weather derivative, and that is usually the reason why financial institutions enter into such a contract. They thus fulfill their classic economic function of risk , deadline and lot size transformation . Banks that can offer their customers such products are usually very active and large participants in the financial markets. A small savings bank or a small VR bank that concludes such a contract with its customer would pass this deal on to such a bank. In practice, however, such small banks are only very rarely likely to act as counterparties to weather derivatives, since even the transfer of such a contract requires business processes that such a bank does not have. The mere question of the accounting treatment of such a derivative can make it unattractive for a savings bank or VR-Bank to take out such an instrument.
Banks that “take weather risks on their books” reduce the risk they have entered into by means of a large number of contracts that are as contradicting as possible and hedge the remaining risk through very active trading on the exchanges on which weather derivatives are traded in a standardized manner. This trading takes place as long as the respective exchanges are open. During the trading hours of the LIFFE , the London or Frankfurt office of a bank would observe the so-called weather risk book and then pass it on to the Chicago colleagues so that they could manage it during the trading hours of the CME .
Private individuals profiting from weather derivatives?
Weather derivatives are usually not products that are concluded by individuals. In tourism, however, some companies occasionally offer their package travelers a "money-back guarantee" if the number of rainy days in the holiday destination is above a specified number. Companies usually put together such offers for marketing reasons. As a rule, the travel agent does not bear the additional weather risk himself, but hedges it by taking out weather derivatives. In this way, the end user can also benefit from weather derivatives.
Private individuals who own shares and are therefore shareholders in a company can also be indirectly affected by weather derivatives. If you, as a shareholder, are interested in a dividend that remains as constant as possible , you will probably welcome the conclusion of such contracts, as these can make a significant contribution to stabilizing corporate profits if used correctly. Those who consciously combine stocks of different weather-dependent companies in order to diversify their portfolio , however, have no interest in only some of the companies in which they are involved hedge their risk through derivatives, as this runs counter to their own diversification strategy. In any case, however, shareholders have an interest in having a corresponding risk management process in place. Both major shareholders and the spokesmen for small shareholder representatives therefore critically question such financial statements and the analyzes on which their financial statements are based. The same applies to employee representatives , whereby employees tend to be among the beneficiaries of correctly used weather derivatives, since companies with stable profits are more likely to offer a secure job than those whose company profits fluctuate sharply due to exogenous factors .
Development of the market
In 1997 a weather derivative was concluded for the first time between two counterparties. In September 1999 the Chicago Mercantile Exchange introduced weather derivatives and European options on weather futures as a standardized exchange product. Contracts were offered, which could have the average measured monthly temperature values of weather stations in Atlanta , Chicago , Cincinnati , Dallas , Des Moines , Las Vegas , New York , Philadelphia , Portland or Tucson as base values .
The development of weather derivatives in the late 1990s was largely shaped by the hope that a rapidly growing market would be seen here: A large number of companies are dependent on the weather, and since the 1980s the use of derivative instruments to hedge interest has been - and exchange rate risks have increased significantly, so that many companies are familiar with the use of these instruments - the basic principles of which also apply to weather derivatives. The expected growth - at the beginning of 2003 still estimated at double-digit annual growth figures - has not yet materialized. Some well-known and large banks, which are normally among the providers of innovative financial products, have even stopped trading these derivatives again.
This development, which was surprising for many market participants, is due to the complexity of hedging with weather derivatives. It is true that neither the dependence of many business activities on the weather nor the possibility for companies to use it to hedge their risks is controversial. However, as the examples above show, companies must first conduct a very careful risk analysis in order to define weather derivatives to match the risk profile. Incorrectly concluded derivatives, instead of hedging, may increase business risk. Conversely, banks must be in a position to value such individually tailored contracts in order to be able to adequately monitor the risks they assume by entering into such a contract. Such weather-based contracts are therefore associated with high costs for both parties, which means that the volume traded is still not very large.
literature
- Stefan Ehrhardt: Risk management with weather derivatives. Conception of a pricing model for wind derivatives to evaluate and hedge weather-induced business risks in wind farms. Grin Verlag, Munich 2009, ISBN 978-3-640-26071-3 .
- Christian Hee, Lutz Hofmann: Weather derivatives. Basics, exposure, application and evaluation. Gabler Verlag, Wiesbaden 2006, ISBN 3-8349-0240-3 .
- Andreas Kamp: WiSt case study: Weather risk management with weather derivatives. In: WiSt - economics studies. 33rd volume, 2004, ISSN 0340-1650 , pp. 252-256.
- Mike Rinker: The acquisition of weather derivatives as a modern risk management measure for cities and municipalities. In: New journal for administrative law. 2004, ISSN 0721-880X , pp. 1452-1454.
- Mike Rinker: Securing the municipal budget through the use of weather derivatives. In: Hessian city and community newspaper. 2005, ISSN 0171-9610 , pp. 161-162.
- Mike Rinker: Weather derivatives. Functionality, legal framework, MiFID, ultra vires doctrine. Erich Schmidt Verlag, Berlin 2008, ISBN 978-3-503-11205-0 .
- Sascha Wilkens, Andreas Kamp: Weather derivatives. In: DBW - Business Administration. 62nd volume , 2002, ISSN 0342-7064 , pp. 116-119.
Individual evidence
- ↑ Eurex Weather Derivatives ( Memento from April 19, 2014 in the Internet Archive )