Valuation and use of Weather Derivatives



Table of Content

Introduction3

Discussion3

Hedging Weather Risk4

Simple Option Pricing7

The Gaussian Pricing Model10

Obtaining the Inputs to the Pricing Model11

Basis Risk13

Hedging With Weather Options and Swaps14

Conclusions16

References17

Valuation and use of Weather Derivatives

Introduction

The first transaction in the weather derivatives market took place in 19971. Since that time, the market has expanded rapidly into a flourishing over the counter (OTC) market. Further growth in the end-user sector is somewhat limited by the credit issues associated with an OTC market (i.e., satisfying the International Securities and Derivatives Association Master Swap Agreement). To increase the size of the market and to remove credit risk from the trading of weather contracts, the some Exchange introducing weather derivatives to be traded electronically. The individual contracts are calendar-month futures (swap) contracts on heating degree days (HDD) and cooling degree days (CDD) as well as options on futures.

Discussion

There are a number of drivers behind the growth of the weather derivative market. Primary among these is the convergence of capital markets with insurance markets. This process is evidenced by the growth in the number of catastrophe bonds issued in recent years as well as the introduction of the catastrophe options that are traded on the Chicago Board of Trade (CBOT). Weather derivatives are the logical extension of this convergence. The overall growth in the 'securitization'of risk in the weather and catastrophe markets shows no signs of slowing. The weather derivative market was jump started during the El Niño winter of 1997-98, one of the strongest such events on record. This event was unique in terms of the publicity that it received in the American press. Many companies, faced with the possibility of significant earnings declines because of an unusually mild winter, decided to hedge their seasonal weather risk. Weather derivative contracts are particularly attractive to businesses that have experience with financial options and futures. The insurance industry was facing a cyclical period of low premiums in traditional underwriting businesses in this same period and was in a position to make available sufficient amounts of risk capital to hedge weather risk. The large base of written options from insurance companies provided the liquidity for the development of a monthly and seasonal swap market in weather (Pirrong, 2006a).

Hedging Weather Risk

A company has a number of alternatives in structuring a weather deal. The first alternative is most similar to an insurance product — to buy a cooling degree day option (CDD) in the case of summer, or a heating degree day option (HDD) for winter. The number of cooling degree days on a single day is the difference of the daily average temperature from 65 degrees Fahrenheit. Cooling degree days and heating degree days are never negative. If the daily average temperature is less than 65 F, then the difference of the daily average temperature and 65 F is the number of HDDs. Over the course of a month, one might accumulate both CDDs and HDDs. Weather options are written on the cumulative HDDs or CDDs over ...