Introduction to Weather Derivatives By Anjelina Belakovskaia Weather Derivatives Trader Head of the Weather Desk at Williams Co. Copyright 2002 © Anjelina Belakovskaia

Weather DerivativesQ: What are Weather Derivatives ? A: Options to buy or sell sun, rain, snow, wind, etc… as well as swaps (exchange rights) on the above. + = Copyright 2002 © Anjelina Belakovskaia

 Somewhere RAIN creates flood.  Somewhere DROUGHT lasts for months.  Some areas are HOT.  Some areas are COLD. Copyright 2002 © Anjelina Belakovskaia

Weather Derivatives are used when: Company’s revenue is sensitive to the temperature, rainfall, snowfall, etc… Weather events are non-catastrophic. Goal is to reduce risk due to weather exposure and decrease volatility of return. Credit exposure has to be diversified. Also as investment strategies: To diversify investment portfolio. To capture inefficiency in the weather market. Copyright 2002 © Anjelina Belakovskaia

WHO BENEFITS? Agriculture (early frost – yield, hot summer – livestock). Construction (work interruption, damage to materials, project risk). Energy (mild winter – less revenue, hot summer – extreme prices). Entertainment (no snow – ski resorts, cold and rainy – Amusement parks). Financial Institutions (uncorrelated to stock market). Food Industry (mild summer – soft drinks and ice cream). Copyright 2002 © Anjelina Belakovskaia

WHO BENEFITS? Heath (pollen - allergies, heavy rains - viruses). Insurance and Reinsurance (hedging some risk). Municipality (heavy snowfalls – budget crisis). Retail (cool summer – T-shirts, mild winter – fur coats). Sport (football, baseball). Transportation (trucks, trains, barges, airplanes). Travel (canceled trips, less demand). Copyright 2002 © Anjelina Belakovskaia

Trading Instruments and Measure: Calls Puts Swaps Digital options Strangles, Collars Baskets Structures CDD – cooling degree days HDD – heating degree days VDD – variable degree days TMAX – max. temperature TMIN – min. temperature Rainfall – inches of rain Snowfall – inches of snow Copyright 2002 © Anjelina Belakovskaia

Weather Calculations: CDD = MAX ( Temp – 65, 0 ) HDD = MAX ( 65 – Temp, 0 ) Temp = Average daily temperature = ( TMAX + TMIN ) / 2 65 => Base temperature (chosen) VDD => Base temperature is different or => TMAX, TMIN is used instead of AVG or => SUM ( CDD & HDD ) Copyright 2002 © Anjelina Belakovskaia

Weather Market: OTC, 5-6 brokers. ICE, CME, LIFFE. Locations: Airports (mainly). Seasons: May-Sep, Nov-Mar, monthly, weekly, multi-year. Size: $1-2 MM Notional (Cap). $ 5,000 per DD. Copyright 2002 © Anjelina Belakovskaia

Pricing Weather Contracts: 10 YR Mean. STD. Swap => around 10 YR Mean. Options => about 1/3 STD from 10 YR Mean. Time Series and Distribution Models. Copyright 2002 © Anjelina Belakovskaia

Electricity Load as a function of Temperature Electricity Load increases with temperature primarily because of the use of air-conditioning. The increase in electricity load because of falling temperatures is smaller because natural gas is used for heating alongside electricity. T > 90 o FT < 32 o F Copyright 2002 © Anjelina Belakovskaia

Electricity Prices as a function of Temperature Electricity Prices increase dramatically as temperature rises beyond 90 degrees Fahrenheit because of supply side constraints. A corresponding increase in electricity prices is not visible when temperature falls to freezing and below. T < 32 o FT > 90 o F Electricity Price Spikes Copyright 2002 © Anjelina Belakovskaia

Trade 1: Long power + Short CDD Calls TRADE OUTCOMES: Very Hot Summer Significant gain on long electricity position due to convexity of power prices with respect to temperature. Linear loss on short CDD Options capped at $ 1 million. Net outcome is a very positive pay-off. TRADE A: Buy July power, when temperature is expected to be above 90o F and price spikes are likely. TRADE B: Sell Out-of-the-Money CDD calls with a cap of $ 1 million. Collect $ 300,000 premium. Mild Summer Loss on long electricity position is partially off-set by the weather option premium. Electricity prices do not fall as quickly. Copyright 2002 © Anjelina Belakovskaia

Trade 2: Long gas + Short Heating Degree Day weather options TRADE OUTCOMES: Very cold winter Significant gain on long natural gas position due to spikes in gas prices when temperature falls. Linear loss on short HDD Options capped at $ 1 million. Net outcome is a very positive pay-off. Mild winter Loss on natural gas position is partially off-set by the weather option premium. This trade is similar to the previous trade. TRADE A: Long natural gas contracts for settlement in Dec, Jan or Feb when temperature is expected to be below 40 o F and price spikes are likely in the natural gas markets. TRADE B: Sell Out-of-the-Money HDD calls with a strike of 1200 and a cap of $ 1 million, when 10-year average of Dec-Feb HDDs is Collect $ 300,000 premium. Copyright 2002 © Anjelina Belakovskaia

History: 1996 – 1997: Aquila, Koch & Enron – 1st weather-indexed commodity transaction. 1999: CME. 2001: ICE, LIFFE. 50 % - Energy. 25 % - Insurance, Reinsurance. 25 % - Other. Copyright 2002 © Anjelina Belakovskaia

WRMA Survey: 1,836 2,959 2,517 4,306 Copyright 2002 © Anjelina Belakovskaia

WRMA Survey: Copyright 2002 © Anjelina Belakovskaia

2001 – 2002 Energy Crisis: “post-Enron” era Energy traders are replaced by Banks, Hedge Funds, Reinsurance Broader variety of sectors: Agriculture, Construction, Entertainment, Sport, Travel and more… Geographical expansion to Asia, Europe & Australia. Copyright 2002 © Anjelina Belakovskaia

New weather markets: Storms, Hurricanes, Tornados Droughts Floods Food production Hydroelectric production Wind farms and more… Copyright 2002 © Anjelina Belakovskaia

New weather products: Many fancy exotic solutions: “Refund for Rainy Days during Holidays” %20CelsiusPro%20and%20AGA%20Collaboration_EN.pdf %20CelsiusPro%20and%20AGA%20Collaboration_EN.pdf WindLock – Wind Power Variability Risk Hedging instrument Copyright 2002 © Anjelina Belakovskaia

Web sites: Copyright 2002 © Anjelina Belakovskaia