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Table of  contents  

  List of figures  2

  List of abbreviations  3

  List of symbols  4

1.  Introduction  5

1.1.  Description of the problem  5

1.2.  Objective of the work  6

1.3.  Scope of work  6

2.  Risk Management and derivatives: Theoretical background  7

2.1.  Risk Management  8

2.1.1.  Definition of Risk  9

2.1.2.  Necessity of Risk Management  11

2.2.  Derivatives  13

2.2.1.  Characteristics and functionality  13

2.2.2.  Types of derivatives  14

2.2.2.1.  Forwards and Futures  14

2.2.2.2.  Options  15

2.2.2.3.  Swaps  20

2.2.2.4.  Caps Floors and Collars  21

2.2.3.  Actors in the market  21

2.2.3.1.  Hedgers  22

2.2.3.2.  Speculators  22

2.2.3.2.  Arbitrageurs  22

3.  Weather derivatives  23

3.1.  Definition and differentiation  23

3.2.  Evolution  24

3.3.  Field of application  27

3.3.1.  Companies and public institutions  27

3.3.2.  Financial institutions  30

3.3.3.  Investors  31

3.4.  Structure  32

3.5.  Underlying  34

3.5.1.  Temperature  35

3.5.2.  Precipitation  38

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3.5.3.  Wind  39

3.6.  Methods of valuation  40

3.6.1.  Black Scholes  40

3.6.2.  Burn-Analysis  43

3.6.3.  Monte-Carlo Simulation  44

3.6.4.  Stochastic models  46

3.7.  Problems in application  48

3.7.1.  Pricing  48

3.7.2.  Legal and fiscal formalities  50

3.7.3.  Regulation of markets  50

4.  Example of use  51

4.1.  Contract parties  51

4.2.  Contract parameters  51

4.3.  Outcome  53

4.4.  Other examples  53

5.  Summary and outlook  54

  Appendix  56

  Bibliography  65

  List of figures  

  Figure 1: Systematisation of risks  10

  Figure 2: Weather influence on different branches  11

  Figure 3: Reasons for risk management  13

  Figure 4: Forward and future payoffs  15

  Figure 5: Win loss profile of a European call option  17

  Figure 6: Win loss profile of a European put option  18

  Figure 7: Development of the notional value of weather derivatives  25

  Figure 8: OTC contracts by region  25

  Figure 9: Stock exchange trade versus OTC trade  26

  Figure 10: Correlation temperature and other assets  31

  Figure 11: Example of weather contract data  33

  Figure 12: Weather indexes  34

  Figure 13: Common term operations  35

  Figure 14: Correlation between monthly power load and heating degree days  36

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  Figure 15: Correlation between billion cubic feet gas load and heating degree days  

  .................................................................................................................................36  

  Figure 16: Wind derivative construction ..................................................................40  

  Figure 17: Steps of Burn Analysis ...........................................................................43  

  Figure 18: Assessment of traditional derivative pricing models ..............................46  

  Figure 19: Index Value Simulation and Daily Simulation Method............................47  

  Figure 20: Contract parameters of Safari-Land weather derivative.........................52  

  Figure 21: Payoff situation for Safari Land .............................................................52  

  List of abbreviations  

  approx. approximately  

  etc. et cetera, and so on  

  vs. versus  

  e.g. for example  

  f. following page  

  ff. forthfollowing page  

  °C degree Celsius  

  CAT Cumulative Average Temperature  

  CDD Cooling Degree Day  

  CME Chicago Mercantile Exchange  

  DSM Daily Simulation Method  

  EDD Energy Degree Day  

  EUREX European Exchange  

  F Fahrenheit  

  HDD Heating Degree Day  

  ILS Insurance-linked securities  

  IVSM Index Value Simulation Method  

  LIFFE London International Financial Futures and Options  

  Exchange  

  OTC Over-the-Counter  

  p. page  

  PWC PricewaterhouseCoopers  

  ref. reference  

  US United States  

  USA United States of America  

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USD US Dollar = US $ WRMA

List of symbols

ά trend rate BE C d e k K P r S S ⁰ σ σ² t T V W

X

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1. Introduction

“Everybody talks about the weather

1.1. Description of the problem

Since the times of the old Greek and Roman mythology, weather is playing an im-portant role in human life. About 80% of the world’s economy is being impacted by the weather and nearly every branch depends on weather conditions in a direct or indirect way. ¹ The ability to hedge price risks of industrial and consumer goods is well-developed an widely used, but, for many customers and companies, a variance in the unit volume being caused by a unexpected weather situation can be as detrimental to the bottom line as unit price variation.

In the past, market participants were exposed defencelessly to this risk, because “weather has been anything but predictable…” ² There was bundle of incidents in the late 90’s which lead to the development of weather derivatives as a new, flexible instrument to mitigate risk resulting from weather:

First, the changing world climate causes more often extreme weather situations such as El Nino. Weather catastrophes like the hurricanes Katrina and Rita in the USA, summer flood of 2002 and the desert summer of 2003 in Germany have been increasing the awareness of weather risks among the population and in the management of the companies. ³ Unforeseen weather conditions may cause a decline in companies’ earnings. ⁴ It is likely to imagine, that, for example, a cold and rainy summer will lead to a plummeting consumption of ice cream.

In times of an upward tending importance of the shareholder value approach, a professional and effective risk management is inalienable. Insurance policies can

¹ See Auer, J. (2003), p. 1.

² Clemmons, L. (1998), p. 997

³ See Wirth, B. (2004), p. 1.

⁴ See Considine, G. (2000), p. 1.

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cover catastrophic damages, but derivatives are an efficient tool to face financial risks resulting from the weather and to stabilize earnings. ⁵ Secondly, the worldwide markets are changing. Formerly strictly regulated markets show an ongoing trend of deregulation and therefore a development from monopolies to wholesale markets. ⁶ Facing a new, competitive situation, companies have to realize, that it does not last to hedge the unit price of their goods. In the mid 90’s, during the liberalization of the American energy market, managers recognized the volumetric risk as a critical parameter influencing companies revenues and expenses. Up to the development of the first weather derivatives, there had been no possibility to cover these risks.

Beside the application in mitigating risks resulting from weather, weather derivatives are used as a marketing instrument. Travel business companies can offer a reimbursement of holiday costs if the weather was bad. ⁷ Since 1996 the market of weather derivatives is increasing continuously. Even in Europe a market is being established. Nevertheless, weather derivatives are still nominated as “real exotics among the financial instruments” ⁸ .

1.2. Objective of the work

This case study aims at giving a background about the characteristics of weather derivatives and the possible future developments of this rather new financial instrument.

1.3. Scope of work

For this purpose, chapter 2 introduces the theoretical background of risk management with derivatives in general. The character, the main occurring types of derivatives and the actors in the market are being pointed out.

Basing on this, the next chapter puts special emphasis on weather derivatives in detail. Starting from the historical development and the wide application field, the discussion about the structure of weather derivatives leads to the problem of valuation. The most common approaches to determine the fair value are being depicted critically.

⁵ See Cao, M., Li, A, Wei, J. (2004), The Journal of Alternative Investments, p. 93.

⁶ See Cao, M, Li, A., Wei, J. (2004), Canadian Investment Review, p. 27.

⁷ See Auer, J. (2003), Handelsblatt (without page)

⁸ Maier, G. (2001) (without page)

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The chapter closes with describing different obstacles which impede the unrestricted application of weather derivatives.

In chapter four, theory is transferred into praxis giving a practical example of use of weather derivatives. Finally the results of the case study are summarized and a short outlook on possible future developments is given.

2. Risk Management and derivatives: Theoretical back-

ground

Companies today face a huge number of risks. Margins are getting smaller, so for most companies, it gets more and more difficult, to handle losses or variation in sales figures etc. So precautions have to be taken to mitigate the threats to the companies to a maximum extent.

Derivative securities can be used to hedge an exposure to risk. They can be used to provide e.g. protection of a price decline in a certain stock, by a put option or a company that enters a currency exchange swap in order to protect against floatations in the exchange rates. ⁹ Derivatives are the most widespread instrument used for managing all forms of risks that threaten companies. They can be traded OTC or on an exchange giving the advantage that they can refer to almost all kinds of underlying and so “you can invest in or hedge anything from beans to bonds, cattle to crude, stocks to silver, gilts to gold, euros to yen and coffee to orange juice”. ¹⁰ Hence, by using derivatives, many market participants can manage their market, credit or other forms of risks. Some examples:

• Financiers/borrowers: can fix costs of lending or borrowing money

⁹ See Jarrow, R. / Turnbull, S. (1999), p. 2 – 3.

¹⁰ See Jolly, A. (2003), p. 146.

¹¹ See Jolly, A. (2003), p. 148

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“The leveraged nature of derivatives makes them an ideal low cost product for managing a variety of different risks and the ability to take on a position based only on payment of a very small deposit makes them hugely attractive as a speculative vehicle”. ¹² This speculative use has led to the huge losses of companies like Metallgesellschaft AG. Board managers have to consider the potential of derivatives to manage a large number of different business risks. By doing so, the managers speculate on the underlying product and risk significant losses. Therefore it is important, to properly monitor and manage the derivative portfolio. 13

2.1. Risk Management

Modern Risk management developed waning form the premium policy of American insurance companies. These companies agreed to reduce insurance premiums for big companies, when the companies were able to exhibit intra corporate security measures. 14 Defined in a narrow sense, risk management is a task of the financial sector: The financial sector defines an upper limit for the risks concerning investments of the company. This limit has to be followed by the management when realizing an investment. In addition to that, the financial sector chooses the financing policy that ensures the solvency of the company and optimises the probability distribution of the company’s success. ¹⁵ Basically, risk management can be seen as an integral part of management practice. It is supposed to be a process that enables continual improvement in decision making. There are several different definitions of risk management as a process. Some authors are of the opinion that the process consists of 4 steps, others specify 5 or even 7 steps. Most commonly mentioned are 4 - 5 steps:

Risk identification: In this first step, uncertainties the company faces have to be identified, risky processes, contracts and areas but also potential chances are tracked. ¹⁶ Risk evaluation: In step two, for each of the identified sources of risk, an evaluation should be performed, regarding potential loss frequency and severity of the

¹² Jolly, A. (2003), p. 148

¹³ See Jolly, A. (2003), p. 148.

¹⁴ See Bitz, H. (2000), p. 16;39.

¹⁵ See Franke, G., Hax, H. (2004), p. 583.

¹⁶ See Frenkel, M. et al. (2005), p. 502.

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respective risk. There are only few cases in which it is possible to measure the risks exactly. In most cases, risk can only be estimated. ¹⁷ Selection of risk management techniques: For each identified risk, the board management has to take decisions how to handle the risk. In some cases, the decision could be to do nothing; in another case ways to finance potential losses may be arranged. This depends on the individual attitude towards risks. Implement decisions: The decisions regarding the chosen techniques then have to be implemented accordingly.

Review decisions: As risk management is an ongoing process, and decisions that were taken earlier have to be reviewed regularly, because risks and risk potentials can change quickly. For this reason a risk monitoring system has to be established. 18

2.1.1. Definition of Risk

“Risk is a feature of all decision making.” 19

In literature, several definitions for risk can be found. One saying, that risk can be defined as the threat, that events or actions keep companies from reaching their goals or realize their strategy. ²⁰ Another definition says that risk is the grade of probability, that due to a certain behaviour, circumstance or action, a disadvantage sets in, or an expected advantage fails to occur. ²¹ Or risk is simply defined as the uncertainty concerning loss. ²² Risk is a part of all spheres in human life, it is inevitable in competition, the economics of trading, investing and competing in a market economy. ²³ There are also several completely different theoretical methods of systemizing risks. In our context, it makes sense to divide risks into operative and financial risks:

¹⁷ See Treischmann, J. et al. (2005), p. 12.

¹⁸ For the Steps, see for example Treischmann, J. et al. (2005), p. 12. ¹⁹ McLaney, E.J. (2000), p. 13.

²⁰ See KPMG (2000), p. 1.

²¹ See Gabler Wirtschaftslexikon on CD-ROM.

²² See Treischmann, J. et al. (2005), p. 13.

²³ See Jolly, A. (2003), p. 145.

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Figure 1: Systematisation of risks 24

Basically, weather risks can be seen as a part of the operative risks of a company, operative risks can then be subdivided by endogenous and exogenous risks. Endogenous operative risks are risks that can be controlled by the company itself, whereas exogenous operative risks are beyond the control of the companies. In this context, weather risks can be seen as exogenous operative risks, as it is impossible for companies to influence the weather. 25

The impact of the weather on the turnover of various branches is depicted in the following table:

²⁴ Own presentation with reference to: www.riskbooks.de/corprisk/risikoarten.htm

²⁵ See Becker/ Hörter (1998), p. 694.

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Figure 2: Weather influence on different branches 26

2.1.2. Necessity of Risk Management

As a consequence of globalisation and liberalisation, the competition that companies are facing today becomes more and more intense. One milestone in the de-

²⁶ Ownpresentation, with reference to: PWC survey (2005).

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velopment of risk management was strong variation of exchange rates and interest rates after the breakdown of the Bretton Woods System. ²⁷ Then there were a number of wake-up calls from corporate disasters, like Enron and WorldCom. ²⁸ Basically is it that due to the fact, that the environment becomes increasingly complex, a growing gap occurs between the required response time needed for the decision-making-process and the actual response time that is at the disposal of the companies. This fact holds risks for the companies, a fact that is underlined by the increasing number of bankruptcies in Germany since the early 1990s. ²⁹ As a reaction to this fact e.g., the German legislation implemented in May 1998 the “Gesetz zur Kontrolle und Transparenz im Unternehmensbereich” (KonTraG). This law, which is meant for stock companies mainly quoted on the stock exchange, says that the board of directors must establish provisions, especially a monitoring system, that is capable of realizing developments that can be a threat to the continuity of the company early enough. ³⁰ KonTraG arrogates stock companies to install a system being able to monitor risks on the basis of risk identification.

For companies there are several reasons for implementing risk management, as demonstrated in the following table:

²⁷ See Franke, G., Hax, H. (1988), p. 581.

²⁸ See Ong, M. (2006), p. 4.

²⁹ See Wolf, K., Runzheimer, B. (1999), p. 63.

³⁰ See AktG § 93.

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Figure 3: Reasons for risk management 31

As already stated in the chapter 1.1., 80% of the world economy is depending on the weather, so this is a risk that is worth a closer look in the management of company risks.

2.2. Derivatives

2.2.1. Characteristics and functionality

Derivatives are financial instruments whose values derive from other, more basic, underlying variables. These underlying variables are in general the prices of traded assets. ³² Theoretically, any asset could be the subject of a derivative. ³³ In practice, the traditional and most common underlyings are currencies, stocks, indexes, interest rates and commodities. ³⁴ Within the last 25 years, there have been many developments in the derivative market. A lot of new types of derivative products have been created. Today there is

³¹ Own presentation with ref. to: M_O_R Management of risks: Guidance for Practitioners, p. 8. ³² See Hull, J. (2006), p.1.

³³ See McLaney, E.J. (2000), p. 12.

³⁴ See Neftci, S.(2000) p. 2.