Transcript 2nd International Conference on Fog and Fog Collection

Weather Derivatives
[presentation to Australian Barley Board, 9 September, 2004]
Dr Harvey Stern
Bureau of Meteorology, Melbourne
Important WEB Sites
• http://www.bom.gov.au
• http://www.artemis.bm/artemis.htm
• http://www.wrma.org
Outline of Presentation
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Recent Weather Risk Management (WRM) news.
WRM products.
Weather Derivatives.
Hedging Applications.
Current state of the global WRM market.
The Noah Rule
“Predicting rain doesn’t count;
Building arks does”.
Warren Buffett,
Australian Financial Review,11 March 2002.
Some Recent News
• The next few slides illustrate some recent news.
Foundation of the Weather Market
“The foundation of today’s financial weather contracts is in
the US power market …
For the weather-sensitive end-user, not to hedge is to
gamble on the weather.”
Robert S. Dischell
The Asia-Pacific Region
• Interest in weather risk management has grown in the
Asia-Pacific Region (covering electricity, gas, &
agriculture). Countries involved include:
- Japan;
- Korea; and,
- Australia/New Zealand.
Source: Weather Risk Management Association.
Australian Developments
• For many years, the power industry has received detailed
weather forecasts from the Bureau.
• Now, Australia has joined the global trend towards an
increased focus on the management of weather-related
risk.
• The first instance of an (Australian) weather derivative
trade occurred about four years ago.
• A number of businesses have now moved into the trading
of weather risk products, almost all “over the counter”.
• Partnerships are emerging between merchant banks and
weather forecasting companies.
Weather-linked Securities
• Weather-linked securities have prices which are linked to
the historical weather in a region.
• They provide returns related to weather observed in the
region subsequent to their purchase.
• They therefore may be used to help firms hedge against
weather related risk.
• They also may be used to help speculators monetise their
view of likely weather patterns.
Securitisation
• The reinsurance industry experienced several catastrophic
events during the late 1980s & early 1990s.
• The ensuing industry restructuring saw the creation of new
risk-management tools.
• These tools included securitisation of insurance risks
(including weather-related risks).
• Weather securitisation may be defined as the conversion of
the abstract concept of weather risk into packages of
securities.
• These may be sold as income-yielding structured products.
Catastrophe Bonds
• A catastrophe (cat) bond is an exchange of principal for
periodic coupon payments wherein the payment of the
coupon and/or the return of the principal of the bond is
linked to the occurrence of a specified catastrophic event.
• The coupon is given to the investor upfront, who posts the
notional amount of the bond in an account.
• If there is an event, investors may lose a portion of (or their
entire) principal.
• If there is no event, investors preserve their principal and
earn the coupon.
Source: Canter & Cole at http://www.cnare.com
Catastrophe Swaps
• A catastrophe (cat) swap is an alternative structure, but
returns are still linked to the occurrence of an event.
• However, with swaps, there is no exchange of principal.
• The coupon is still given to the investor upfront, but the
structure enables investors to invest the notional amount
of the bond in a manner of his own choosing.
Source: Canter & Cole at http://www.cnare.com
Weather Derivatives
• Weather derivatives are similar to conventional financial
derivatives.
• The basic difference lies in the underlying variables that
determine the pay-offs.
• These underlying variables include temperature,
precipitation, wind, and heating (& cooling) degree days.
Derivative or Insurance?
• A Derivative:
-has ongoing economic value,
-is treated like any other commodity,
-is accounted for daily, &
-may therefore affect a company’s credit rating.
• An Insurance Contract:
-is not regarded as having economic value, &
-therefore does not affect a company’s credit rating.
A Weather-linked Option
• An example of a weather linked option is the Cooling
Degree Day (CDD) Call Option.
• Total CDDs is defined as the accumulated number of
degrees the daily mean temperature is above a base figure.
• This is a measure of the requirement for cooling.
• If accumulated CDDs exceed “the strike”, the seller pays
the buyer a certain amount for each CDD above “the
strike”.
Specifying the CDD Call Option
• Strike: 400 CDDs.
• Notional: $100 per CDD (> 400 CDDs).
• If, at expiry, the accumulated CDDs > 400, the seller of the
option pays the buyer $100 for each CDD > 400.
Pay-off Chart for the CDD
Call Option
An Historical Note:
An Early Example
• In 1992, the present author explored a methodology to
assess the risk of climate change.
• Option pricing theory was used to value instruments that
might apply to temperature fluctuations and long-term
trends.
• The methodology provided a tool to cost the risk faced
(both risk on a global scale, and risk on a company specific
scale).
• Such securities could be used to help firms hedge against
risk related to climate change.
Carbon Disclosure Project (2003)
• "Investors failing to take account of climate change and
carbon finance issues in the asset allocation and equity
valuations may be exposed to significant risks which, if left
unattended, will have serious investment repercussions
over the course of time."
Cooling Degree Days (1855-2000)
(and climate change)
• Frequency distribution of annual Cooling Degree Days at
Melbourne using all data:
Cooling Degree Days (1971-2000)
(and climate change)
• Frequency distribution of annual Cooling Degree Days at
Melbourne using only recent data:
Should Companies Worry?
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In the good years, companies make big profits.
In the bad years, companies make losses.
Doesn’t it all balance out?
No. it doesn’t.
Companies whose earnings fluctuate wildly receive
unsympathetic hearings from banks and potential
investors.
Weather-related Industry Risk
"Shares in Harvey Norman fell almost 4 per cent yesterday
as a cool summer and a warm start to winter cut into sales
growth at the furniture and electrical retailer's outlets…
Investors were expecting better and marked the shares
down 3.8 per cent to a low of $3.55…
Sales at Harvey Norman were hit on two fronts. Firstly, air
conditioning sales were weak because of the cool summer,
and a warmer than usual start to winter had dampened
demand for heating appliances”.
Source: The Australian of 18 April, 2002
Weather-related Agricultural Risk
“The Australian sugar industry is facing its fifth difficult
year in a row with a drought dashing hopes of an improved
crop in Queensland, where 95% of Australia's sugar is
grown...
Whilst dry weather during the May-December harvest
period is ideal for cane, wet weather during this time
causes the mature cane to produce more shoots and
leaves, reducing its overall sugar content”.
(Australian Financial Review of 8 May, 2002)
The Road to
Weather Risk Management.
• The era of (mostly) categorical forecasts.
• The rapid increase in the application of probability
forecasts.
• The provision of forecast verification (i.e. accuracy) data.
• The era of the “guaranteed forecast”, with user
communities being compensated for an inaccurate
prediction.
• The purchase of “stakes” in the industry (by multi-national
companies).
Pricing Derivatives
There are three approaches that may be applied to the pricing
of derivatives.
These are:
•Historical simulation (applying "burn analysis");
•Direct modelling of the underlying variable’s distribution
(assuming, for example, that the variable's distribution is
normal); and,
•Indirect modelling of the underlying variable’s distribution
(via a Monte Carlo technique).
Returning to the Cane Grower
• Suppose that our cane grower has experienced an
extended period of drought.
• Suppose that if rain doesn't fall next month, a substantial
financial loss will be suffered.
• How might our cane grower protect against exceptionally
dry weather during the coming month?
One Approach
• One approach could be to purchase a Monthly Rainfall
Decile 4 Put Option.
• Assume that our cane grower decides only to take this
action when there is already a risk of a dry month.
• That is, when the current month's Southern Oscillation
Index (SOI) is substantially negative.
• So, the example is applied only to the cases when the
current month's Southern Oscillation Index (SOI) is in the
lowest 5% of possible values, that is, below -16.4.
Specifying the Decile 4 Put Option
• Strike: Decile 4.
• Notional: $100 per Decile (< Decile 4).
• If, at expiry, the Decile is < Decile 4, the seller of the option
pays the buyer $100 for each Decile < Decile 4.
Payoff Chart for Decile 4 Put Option
Outcomes for Decile 4 Put Option
Evaluating the Decile 4 Put Option
• 14.2% cases of Decile 1 yields $(.142)x(4-1)x100=$42.60
• 13.2% cases of Decile 2 yields $(.132)x(4-2)x100=$26.40
• 8.4% cases of Decile 3 yields $(.084)x(4-3)x100=$8.40
• The other 25 cases (Decile 4 or above) yield nothing.
…leading to a total of $77.40, which is the price of our put
option.
Weather & Climate Forecasts
• Daily weather forecasts may be used to manage short-term
risk (e.g. pouring concrete).
• Seasonal climate forecasts may be used to manage risk
associated with long-term activities (e.g. sowing crops).
• Forecasts are based on a combination of solutions to the
equations of physics, and some statistical techniques.
• With the focus upon managing risk, the forecasts are
increasingly being couched in probabilistic terms.
Finally … Ensemble Forecasting
• Another approach to obtaining a measure of forecast
uncertainty, is to use ensemble weather forecasts.
• The past decade has seen the implementation of these
operational ensemble weather forecasts.
• Ensemble weather forecasts are derived by imposing a
range of perturbations on the initial analysis.
• Uncertainty associated with the forecasts may be derived
by analysing the probability distributions of the outcomes.
• A parallel approach is to “run” different models with the
same initial analysis
• Spot the differences on the next slide …
Weather Risk Management Association
Results of 2004
Pricewaterhouse Coopers
Survey…
June 10, 2004
Weather Events Determining Contingent Payments
Weather Measures Depending Exclusively on Temperature
Heating-degree-days measured in Fahrenheit
Heating-degree-days measured in Celsius
Cooling-degree-days measured in Fahrenheit
Cooling-degree-days measured in Celsius
Other exclusively temperature-based measures
Weather Measures Not Depending Exclusively on Temperature
Any measure based exclusively on rainfall
Any measure based exclusively on snowfall
Any measure based exclusively on wind
Any other measure, including combinations of the above
Geographic Regions Where Weather Events are Measured
Asia
Australian Continent
Europe
North America, West
North America, Midwest
North America, East
North America, South
Other
9%
7%
4%
13%
11%
Energy
Agriculture
Retail
Construction
Transportation
Other
56%
Reported values weighted by number of trades reported by respondent.
Total Notional Value (in millions of U.S. dollars)
$4,578
$4,339
$5,000
$4,188
$4,500
$4,000
$3,500
$3,000
$2,517
CME
Winter
Summer
$2,500
$2,000
$1,500
$1,000
$500
$0
2000/1
2001/2
2002/3
2003/4
Distribution of Number of Contracts by Type
(No CME trades)
100%
Other
Wind
Snow
Rain
Oth Temp
CDD
HDD
80%
60%
40%
20%
0%
2001/2
2002/3
2003/4
Trades by Type of Contract, 2003-4 Survey
Number of Trades (No CME)
Notional Value (No CME)
7%
16%
17%
49%
32%
52%
18%
HDD
CDD
9%
Oth Temp
Other
HDD
CDD
Oth Temp
Other
Shares including CME trades:
HDD: 56%, CDD: 19%, Other
Temp: 20%, Other: 4%.
Distribution of Total Number of Contracts by
Region
(No CME Trades)
100%
90%
80%
Other
Europe
Asia
NA East
NA Mwest
NA South
NA West
70%
60%
50%
40%
30%
20%
10%
0%
2000/1
2001/2
2002/3
2003/4
Share of Counter-parties Not Participating in
Survey
(As a share of total number of contracts)
80
70
60
50
40
30
61
60
2000/1
2001/2
74
74
2002/3
2003/4
20
10
0
Summary
• The total value of trades in the
2003/4 survey reached $4.6 billion
• The CME again experienced
significant increases in both the
number of trades and the value of
those trades
• The characteristics of the OTC
market based on the 2003/4 Survey
are similar to the results from last
year in terms of type of contracts
and geographic distribution