Weather derivatives

Now that some habrovchane mastered carrot derivatives, you can move on to more complex and much more real weather derivatives. The use of weather forwards may seem incredible, but the market for these tools does not just exist, its volume in the United States exceeds $ 40 billion.

Attention: the post is written by dob habrauzer - and address all the advantages to karma, which was not enough to post a post on a thematic blog.

Update: the post was read by my wife, who deals with finances and also makes a master in this specialty. She said that “weather derivatives” are just a very special case, and if we understand how derivatives work at all, they can be done for anything, even for the health of Her Majesty the Queen, even for the level of precipitation in Rio de Janeiro, the main thing - that it was necessary for someone. One day I will try to get her to write a post here ... (your sigizmund ).
')

What are weather derivatives?

Even in our high-tech society, we are still heavily influenced by the weather. It depends on it, what we will go out today and whether we go on a picnic. It is not surprising that weather conditions also have a significant impact on the profits of companies in many industries: construction is stopped at low temperatures, energy companies suffer losses in the case of a warm winter, and amusement parks in the case of a cold summer. American researchers estimated that revenues of about 20% of the US economy are directly dependent on weather conditions. So that companies could somehow protect profits from the vagaries of nature, there are insurances. However, they can only protect against sudden and significant changes in weather conditions, which occur extremely rarely. Companies also need a more flexible mechanism that will allow them to cover losses in the event of ordinary temperature changes. Weather derivatives have become the mechanisms of this type.

Definition

Weather derivatives are financial contracts, payments for which are directly dependent on weather conditions. It is this connection with the weather that allows them to be used to protect the company's profits from adverse environmental conditions. It is worth saying that payments on any derivatives depend on the value of an asset (for example, shares). Weather contracts are no exception, but the asset in this case is less obvious. If we make contracts based on the weather, then we need to somehow "measure" the weather. The simplest and most common gauge in this case is the temperature. However, there are contracts that are on the amount of precipitation and even wind speed.

How weather contracts work

Building a weather index

As mentioned earlier, one of the indicators for measuring weather is temperature. In practice, not only the thermometer readings are used, but the weather indices CDD (Cooling Degree Day) and HDD (Heating Degree Day) are used. The first is used in the warm months of the year, the second - in the cold. CDD is calculated as the number of degrees by which the average daily temperature is greater than 18 ° C. That is, CDD = average temperature minus 18 ° C. If the average temperature is less than 18 ° C, then CDD is assumed to be 0. For example, if the average temperature per day is 28 ° C, then CDD = 28 - 18 = 10. The HDD is calculated in the same way, the difference is that it is considered 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 conclude a contract for a specific day, it is more convenient to conclude it immediately for a longer period. For example, an energy company does not care what the temperature will be on a particular day, but more significantly 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 daily indices.

Calculate payments for weather forward

Let's see in a simplified situation how the simplest weather derivative works - the forward. For the conclusion of the forward need two sides. In our case, this will be a road builder and an ice cream maker who wants to sign a contract for the temperature expected tomorrow. If tomorrow is very hot, the builder will not be able to build roads and suffer losses in the amount of $ 500, while the icemaker, on the contrary, will be able to sell more ice cream and get super profits of $ 1,500. If tomorrow is cooler than usual, the ice cream maker does not sell as much ice cream as he planned, and will suffer losses of $ 200, and the builder, on the contrary, will build everything on time and even in large volumes, earning a super profit of $ 2000. To get rid of weather risks, they can conclude a forward contract for the temperature that will be tomorrow. Suppose they agreed that the contract temperature would be 28 ° C (= 10 CDD), and the contract value was $ 100. This means that at temperatures above 28 ° C the ice maker will pay $ 100 for each “extra” degree, 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, for example, 35 ° C, then the ice cream man will sell more ice cream than usual and will get super-profits, but he will have to pay $ 700 (= (35-28) × 100) to the builder. The latter, although it will suffer losses due to the inability to work in the heat, will receive $ 700 from the ice-maker. If the temperature drops below 28 ° C, for example, to 23 ° C, then the icemaker will suffer losses in this situation, but will receive payments under the contract worth $ 500, and the builder will build more roads and receive super-profits, but some will have to pay the ice cream maker. In the end, it turns out that whatever the weather happens tomorrow, each of our actors will be “insured” in case of failure and will always remain at least in a small, but positive. Indeed, they will not be able to make excess profits, however, they will not remain at a loss (see Table 1).