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Weather derivatives and its current market scenario

Weather derivatives and its current market scenario

Shubhangi Mehrotra
By Shubhangi Mehrotra
April 27, 2015

Introduction

The weather has an impact on all human beings in their everyday life. One-third of businesses worldwide are directly affected by weather conditions[1]. Weather challenges a wide spectrum of businesses: utilities, transportation, construction, retail, agriculture, real estate and a never-ending list of sectors whose revenues, cost and financial performance are sensitive to weather events. Weather derivatives are used as effective tool for managing risk in agriculture and power sector. The dynamic weather changes are encouraging business to use weather risk management tools to hedge against adverse weather events. Even though major advances have been made in meteorology, predicting weather has still not been accurate. Therefore, a special financial instrument known as weather derivatives is established to allow businesses and other organizations to insure themselves against fluctuations in the weather.

Weather derivatives are structured as swaps, options and futures based on different underlying weather indices. Most of them are traded on OTC (Over the counter) market. However, two exchanges – CME (Chicago Mercantile Exchange) and LIFFE (London International Financial Futures and Options Exchange) offer standardized weather contracts on their respective trading floors. The recent growth in weather derivative can be attributed to hedge funds as they are buying weather contracts in order to diversify their investments.

Currently, the global market size is estimated to be US$76 billion1. The CME Group offers weather risk products related to temperature, snowfall, frost and hurricanes. Temperature contracts are the most traded weather hedge around the world. All the products are designed on the basis of weather conditions and are in more than 47 countries across the world.

Current Scenario of Weather market

The Weather derivatives market is taking-off all around the globe and gaining popularity among all the sectors of businesses. Market participants say that around 90% – 95% of global weather derivatives volumes come from the US with Europe supplying the major portion of the remainder. Other countries including Japan, Australia and India have also started trading on weather derivatives[2].

At present, the uses of weather derivatives are being introduced to a variety of new-sectors as innovative products are launched customized for each industry. The insurance industry has started to hedge against weather risk by investing in weather derivatives. The World Bank has also initiated the use of weather derivatives to ease the effects of famine and droughts in Africa.

As compared to other financial derivatives, weather derivatives do not have pricing model to predict the prices in the future. It is difficult to price the contract as the weather is not a tradable asset. The pricing models are still in the development stage to value the weather derivatives.

Indian market

In a country like India where weather forecast continues to be inaccurate, the impact of weather on business cannot be estimated accurately. Many pilot programmes and initiatives have been undertaken to spread awareness about weather derivatives in India.

A consultant from the CIRM (Centre for Insurance and Risk Management) estimated India’s OTC (Over the Counter) weather derivatives market is worth around $1 billion. NCDEX (National Commodity and Derivatives Exchange) and MCX (Multi Commodity Exchange) both provide trading platform for weather derivatives. The evolution of weather derivatives in India has been slow due to the following reasons:

  • Firstly, lack of availability of reliable weather data.
  • Secondly, the lack of product knowledge and regulatory issues in the country.
  • Thirdly, it involves high cost of risk transfer. It is not always true that relationship between weather and crop yield is straightforward.[3]

Weather derivatives can be a success in India if

–          Appropriate measures are undertaken to minimise basis risk

–          Realistic weather derivative products are designed

–          Sustainable and attractive pricing

–          Timely payout

Despite of many issues regarding weather derivatives, it remains attractive and flexible tool for risk manager to hedge their risk not only in India but all over the world[4].

Conclusion

The movement of weather market has been roughly in line with the rise and fall of the wider financial sector and general economic conditions. However, lack of education among potential users has remained a major barrier for its development. The growing knowledge of participants and comfort level with weather derivatives is leading to the development of more complex offerings which continues to evolve in the market.

When weather disaster hits, developing countries suffer more than developed countries as most developing nation’s economies rely heavily on agriculture and thereby weather. Weather derivatives are still at its niche stage in developing countries like India, South Africa and Ethiopia just to name a few.

The rapid changes in climatic conditions will make it necessary to adopt weather derivatives as a hedging vehicle for businesses. On daily basis, new strategies and products are being introduced in weather market to hedge weather risk. The weather derivatives are emerging and are expected to have a bright future all over the world.

References:

[1] D’Ecclesia, R. (2013). Commodities and commodity derivatives.

[2] Bruce, R. (2008). Every cloud… pages 26-30.

[3] Paul, J. (2013). A study on the feasibility of weather derivatives in india. Indian Journal Research, 2:2.

[4] Sukhija, K. (2008). Emergence of weather derivatives in india. Master’s thesis, The University of Nottingham.

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About the author:

Shubhangi has done her Masters in Mathematical Finance. She is currently working with CPG client on Pricing and Promotion analysis at Fractal.

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