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Derivatives Management
Under the Guidance of Dr. Alok Pandey
• MARKET MAKERS
• BROKERS
• END USERS such as Gas and power marketers and utilities etc.
These weather measures are used to measure the demands that arise due to
the departure of the average daily temperatures from a base level.
An HDD (or CDD) is the number of degrees the day’s average temperature is
above (or below) a base temperature. They are calculated as follows:
Where,
A few other measures used in Weather derivatives are: Energy Degree Days
(EDDs), measured as the sum of HDD or CDD for each day, Growing Degree
Days (GDDs) defined as the degrees between a certain range. GDDs are
used often in agriculture.
Most weather derivative trading are either swaps, or call and put options or a
combination of these. Customized structures have started coming up based
o specific needs, like binary or digital options. These either pay a fixed sum
or zero depending on whether the pay-off is satisfied. Double trigger options
are another example, which pay-off only if the two conditions are met.
Contracts are usually capped, i.e. only a maximum amount of payout can
change hands. This is done so as to limit the maximum amount of payout by
any of the counterparties.
Call and Put Options
As mentioned earlier, HDDs and CDDs act as the underlying asset for the
weather derivatives. Since weather is not a tradable asset, a dollar value is
linked to every degree day in the pay-off calculation.
where,
An investor, who has purchased (is long) the call option, will receive the pay-
off if the recorded HDD or CDD for the season are greater than the strike K.
An investor who has purchased the put option on the other hand will receive
the pay-off if the HDD or the CDD are lower than the strike.
The reason a cap is specified on the call and put options is to avoid excessive
pay-offs. The pay-offs are then defined as,
Pay-off swap: {Min (p ($ / DD) *(Max (0, Xt|T – K), h)} – {Min (p
($ / DD) *(Max (K - 0, Xt|T), h)}
An investor who is long the swap, will receive payments, if the recorded HDD
or CDD are greater than the strike, and will make payments, if the recorded
HDDs or CDDs are lower than the strike.
Collars (Fences)
A collar is a spread position that insulates the buyer from extreme
movements in the underlying asset. It consists of purchasing an OTM call (or
put) with a particular strike, and financing this with the sale of an OTM call
(or put) with a different strike.
Pay-off collar: {Min (p ($ / DD) *(Max (0, Xt|T – K1), h)} – {Min (p
($ / DD) *(Max (K2 - 0, Xt|T), h)}
PRICING OF WEATHER DERIVATIVES
When the trading of weather derivatives started initially in 1997 there were a very
few participants in this market and there were huge bid ask spreads but currently
when the number of participants has increased significantly this bid ask spread has
reduced drastically.
The following table mentions the measuring stations and ticker symbols of futures
contracts that are traded in Chicago Mercantile Exchange.
One can price weather derivatives using one of the many ways available.
• Some models focus on the HDD and CDD directly. The problem with
this approach is that after we calculate the weather measure by
modeling HDD or CDD directly, a lot of information is lost as the values
of HDD and CDD can be zero also.
• Some models focus on temperature directly and then extract the HDD
and CDD for each temperature scenario. This method is a better and a
more comprehensive method.
The example mentioned below clearly shows what information can be lost if
we decide to model HDD and CDD directly. Two locations which are
geographically separate and having very different temperatures can have
same number of degree days.
Even though many models of forecasting the weather conditions exist but
still accurate predictions is not possible and is full of uncertainty. However
some short-term trends can be predicted. Hence one can predict today’s
weather with more certainty as compared to tomorrow’s weather and
tomorrow’s weather. Similarly tomorrow’s weather can be predicted with
more certainty as compared to next week’s weather.
Fisher Black and Myron Scholes developed option pricing model which is
used to determine prices of Call and Put options and is used currently also.
Unfortunately, the Black-Scholes model is based on certain assumptions that
do not apply realistically to weather derivatives. One of the main
assumptions behind the model is that the underlying of the contract (in our
case HDD or CDD) follows a random walk without mean reversion. In other
words, their model predicts that the variability of temperature increases with
time, so temperature could wander off to any level whatsoever. In the figure
attached below, we can see different simulated daily temperature values for
a three month period assuming that there is no mean reversion. The
simulated temperatures differ substantially from expected temperatures,
and we can see how the variability increases with time. We can see how
these simulated temperatures are totally unrealistic, since towards the end
of the simulation, we have temperatures as high as 140 and as low as 0
degrees for the same day of the year.
The Black-Scholes model is probably inadequate for weather derivatives for
the following reasons:
• Weather does not “walk” quite like an asset price “random walk”, which
can in principle wander off to zero (think of degrees Kelvin) or infinity (hotter
than the sun). Instead, variables such as temperature tend to remain within
relatively narrow bands, probably because of a mean-reverting tendency, i.e.
a tendency to come back to their historical levels.
• Weather is not “random” quite like an asset price random walk. Because of
its inherent nature, weather is approximately predictable in the short run and
approximately random around historical averages in the long run. This
means that short-dated weather derivatives may behave fundamentally
different than their long-dated counterparts.
We have seen the how popular the weather derivatives have been U.S.A. there the
major customers for weather derivatives have been utility companies but by
Chicago mercantile exchange’s own admission the real potential will be tapped
when farming related activities start using the weather derivatives. Weather
derivatives have been launched in India as well. Here the major customers will be
the farming community. We don’t see a huge potential for the derivatives by utility
companies as India is a power shortage nation and we don’t see the chances of
excess power due to cooler summers or warmer winters. The reasons why we think
the weather derivatives will be success in India are:
● Farmers
● Agriculture credit off-take in ninth plan – Rs. 2,31,798 crores (grew @
20% pa); Target for X plan – Rs. 7,36,570 crores
● 90% crop losses on account of weather related risks
● Rural Economy is highly weather dependent
● Commodity Traders
● Weather related supply bottlenecks make dry-land commodities very
volatile
● Intraday volatility of Guar, chilly touches 10-15% (daily trading
at national exchanges touches Rs.1000 crore daily)
● Vegetable and fruit Mandis highly dependent on temperature (Delhi
Mandi trade alone touches Rs.1000 crore annually)
● Trader income dependent on weather vagaries
The major U.S firms that trade in weather derivatives are utility companies whose
business is more affected by temperature as compared to rainfall patterns. Whereas
in India farming community is more dependant on rainfall patterns as compared to
the temperature fluctuations.
● EID Parry sales, net down 86 pc on monsoon failure. - The Hindu, Jan 17,
2003
● The Company's business is seasonal in nature and the performance can be
impacted by weather conditions - Notes to Accounts, Syngenta (I) Ltd.
● Monsanto India continued its strong profit growth on the back of positive all-
round business performance aided by a good monsoon. - Annual Report
2003-04, Monsanto Ltd
● The delayed monsoon has hit the fertilizer stocks badly. - Analyst, Hindu
Business Line
● Over 1000 farmers commit suicide in vidarbha and Telangana in last two
years – TOI
● An average drought costs upto Rs 4 bn to the state exchequer, Gujarat
earthquake resulted in direct damages of about Rs.153 billion –NDMC
● Agricultural loss in many parts of the country is weather dependent
● Weather Derivatives can fill in the gap
● Loss can be monitored real time
● Cost of risk transfer can be reduced through weather trading
● Weather (esp. rainfall) is the common commodity across diverse agri-
products, industries
● Explains up-to large variation in prices for commodities in the dry land
● Entities on both the long and short side
First thing that needs to be done is to create the much needed cash/spot market in
India. Then we need to create an active futures/options trading market in India
● Technology development
● Resolving the key constraints
Developing the secondary market in tandem
To achieve these goals we need to cover important agricultural zones real time, at a
cost of approx. Rs.500 per sq.km or Rs.5 per hectare. This figure has been worked
out by weather risk management services.
We also need to generate historical records for any given longitude latitude
positions. Statistical & Neural Network model models need to be developed and
implemented
Since weather derivatives are needed for specific areas we need to collect data for
each particular region. Since India is a monsoon dependant economy we therefore
need to study water imbalances in each city and region for pricing the contracts
This illustration shows that impact of rain is different during different phases of
vegetation. Since there will be contracts with different maturity dates these factors
need to be kept in mind before we price a derivative
Another factor that should be kept in mind is the modeling extreme weather risk.
We need to keep in mind these losses and thus prepare models to identify and
evaluate the risks caused on account of extreme weather conditions. This will be
something in line with value at risk model and stress testing which is used for the
traditional derivative contracts
So considering all this factors and combining it with the satellite images, we will get
something like this which we need to look at while pricing the derivatives.
We will need the standard deviation and the mean of the rainfall and temperature
for the area to be able to compute the price using Gaussian model for pricing of
derivative contracts.
The first thing that the company does is to derive the time series data of 53 winters measured in the city.
the town from where the company operates is a cold place. Average monthly temperatures in winter can fall to
14°F (-5°C), with frequent temperatures below zero.
There is almost perfect correspondence between average winter temperature and November through March
heating degree-days (correlation coefficient is 0.98).
Three warmer-than-average winters in a row have happened twice before in this last half century, but four in a row
have not.
Also the forecast for the coming winters is that it will be warmer than normal.
After obtaining the weather pattern we need to study the basis risk of the company between heating in the
company's distribution region and the weather measurements. We also need to find out the correlation
between the temperature at the measuring site and the regional weather. We also need to find out what is
the temperature which leads to an increase in temperature which results in an increased demand.
We also need to quantify the natural weather exposure of the company. Knowing company’s weather
exposure will help know the risk associated with it.
The chart above shows the gross revenue levels off in extremely cold weathers ( the upper
curve).however when there is extreme demand the company runs out of fuel and has to buy more from
the open market at higher cost. The net revenue can go negative( the lower curve). It can be seen from
the graph that the critical net revenue for the company is not zero but 3 million.
The net revenues become negative when there are less than 4750 heating degree days and when it is
more than 6050 hdd’s
Next we need is the probability distribution of the weather conditions. Using the daily temperatures of last
thirty years we simulate the forecasts. Using the data available in the example we see that 14% of the
times the HDD’S are less than the critical figure of 4750 while 2% times HDD are more than 6050, the two
critical values.
To hedge this risk we need to buy an out of money HDD call which will pay if winters are too cool and sell
a near the money swap that will pay if the winter is warm. The company will have to pay some cash for
the call and sacrifice some revenues in the swap deal but only if winter is cold and revenues are good.
Taking the 30 yr average HDD we price the swap near 5175 HDD. To ensure 3 million revenue we need
to price each HDD at 10,000. The call should be bought below 6050 and should compensate both for
revenue loss and the premium paid for shorting a swap. We can calculate the strike using some software.
Suppose the strike works out at 5850 and the 20,000 for each HDD. The fair value works out at 75,000.
By multiplying the revenue at each degree day occurrence with the probability of that occurrence we get
the probable revenue curve. This way they can ensure that their revenue never goes below the critical
revenue. Thus by buying a swap and selling a call helps them to hedge the risk of revenue falling below
the critical 3 million mark no matter what the weather conditions are.