WEATHER DERIVATIVE

Presented by
1.
2.
3.

Nitin Awasthi
Abhilash Gupta
Kumar Vivek

Faculty :- Nishant Garg

What is Weather Derivative

* Financial Products that allow

companies to manage or
hedge their weather related
risk exposures
*Weather Risk - Revenue or
profits that are sensitive to
weather conditions

Weather Derivative Basics

*Like Financial derivatives, Weather
derivatives are used to hedge risk
*The value of a Financial derivative
depends on the value of an underlying
asset, index or commodity
*The value of a Weather option
depends on the value of an underlying
weather statistic
*Weather Derivatives protect against
abnormal weather outcomes

Who required Weather Derivatives / Hedging

Risk Holder

Weather Type

Risk

Agriculture

Rainfall, Temperature

Crop yield, Storage, Pest

Beverage companies

Temperature

Lower sales during cool summers

Hydroelectric power Plant Rain fall

Low revenue during droughts

Ski-resorts

Snowfall

Lower revenues during low snowfall

Temperature

Lower demand of products which are

weather sensitive like low sales of
winter clothes during warm winters

Temperature

Lower revenues during cool

summers/hot winters.

Snow Fall / Rain Fall

Extra Labor cost if heavy Snow Fall /

Too Much Drainage Blockages if
Extra rain Fall

Retailing
Energy

Municipalities

Example - Snow Removal

Problem: The municipality of Fort Wayne, IN
has spent $3,000,000 to provide for snow
removal for the upcoming winter. This money
will fund the equipment and labor to remove
12 inches of snow. Because of overtime rules,
the municipality estimates that every
additional1/2 inch of snow leads to an
additional $250,000 of snow removal costs.
Solution: A Snowfall call option which pays
$250,000 per 1/2 inch of snowfall above a
strike of 12 inches to a maximum of 20 inches.

Snowfall Call Option

Call Option
Features
Removal Cost (Millions)

Period = Nov-Mar
Strike = 12 inches
Limit = 20 inches
Tick= $250,000
Limit =
$4,000,000
Price = $500,000

5.0

4.5

Unhedged Costs

4.0

3.5
Hedged Costs

3.0

2.5
9

12

Inches of Snow

15

18

Snowfall Distribution
Snowfall Probability Distribution
16%
Below the Strike

14%

Above the Strike

12%
10%
8%
6%
4%
2%
0%
6

10

11

12

13

Inches of Snow

14

15

16

17

18

Removal Costs With & Without

the Call
Probability
4.0%
5.0%
7.0%
9.0%
10.0%
12.0%
15.0%
12.0%
10.0%
8.0%
4.0%
3.0%
1.0%

Inches of
Snow
6
7
8
9
10
11
12
13
14
15
16
17
18

With
Call
3,500,000
3,500,000
3,500,000
3,500,000
3,500,000
3,500,000
3,500,000
3,500,000
3,500,000
3,500,000
3,500,000
3,500,000
3,500,000

Without
Call
3,000,000
3,000,000
3,000,000
3,000,000
3,000,000
3,000,000
3,000,000
3,500,000
4,000,000
4,500,000
5,000,000
5,500,000
6,000,000

Average

12

3,500,000

3,465,000

Effect of the Call Purchase

If the total snowfall exceeds 12
inches - the payoff from the call
exactly offsets the increased cost of
snow removal
Fort Wayne guarantees snow
removal costs of $3.5 mil
Variability is reduced - although
Expected Cost is actually higher