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THE WEATHER MARKET

THE WEATHER MARKET. Rodney R. White University of Toronto. This presentation is based on an unpublished paper written with Sonia Labatt. “Weather derivatives: new market instruments for the transfer of weather risks”. Definition:.

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THE WEATHER MARKET

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  1. THE WEATHER MARKET Rodney R. White University of Toronto

  2. This presentation is based on an unpublished paperwritten with Sonia Labatt.“Weather derivatives: new market instruments for the transfer of weather risks”

  3. Definition: ‘A derivative is a financial contract whose value derives from the value of some underlying asset, such as a stock, bond, currency or commodity.’ Swiss Re, 2001. Capital market innovation in the insurance industry

  4. The weather market has evolved to cover the risk of adverse – not catastrophic – weather

  5. Example: • ‘Adverse weather’ for the energy sector includes mild summers and mild winters

  6. Other examples: • Low precipitation for hydro-electric power generators • Low precipitation for agriculture • Rainfall and frost for the construction industry • Cool, damp weather for outdoor entertainment, beverage sales etc.

  7. The weather contract matches … • The business risk, such as reduced revenue, with the weather index for an agreed contract season.

  8. Example: the energy sector • Business risk = reduced revenues associated with mild summer and mild winters. • Weather index = cooling degree days (CDD) and heating degree days (HDD)

  9. Example continued ….. • CDDs (and HDDs) are measured in the USA as maximum temperature (minimum temperature) compared to 65°F (18°C) • Thus, a daily maximum temp of 75°F produces 10 CDDs for that day

  10. Example continued ….. • The cumulative ‘cooling degrees days’ are then totaled over an agreed period, e.g. a 3-month, or 6-month, ‘cooling season’. The energy company receives payment on the contract if the cumulative CDDs fail to reach an agreed total.

  11. The growth of the weather market • First traded derivative 1997, based on a temp index (HDDs) for Milwaukee for the 1997-98 winter. • All trading was OTC until the CME began listing derivatives based on 10 US cities in 1999.

  12. Emerging products: • For wind farms, risk found both in too little wind and too much wind • For the construction industry, risk may be transferred for wind, frost and rain in a hybrid contract

  13. Emerging products cont. …. • In developing countries agricultural protection from adverse weather based on an index would be much cheaper than conventional crop insurance. • Critical day insurance can protect retailers, tourism, ski resorts etc.

  14. Climate change. • Climate change will increase uncertainty about the weather. • Uncertainty means that the historical weather record becomes a less reliable guide to the future. • Uncertainty will increase the premium for weather risk transfer.

  15. Richard Sandor “It took almost three years for the first trade to occur in the Acid Rain Program, and now that market is worth $4 billion. History has taught us that environmental markets need time to mature.” In Environmental Finance, 2004

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