Weather derivatives

The effects of weather catastrophies on economy


Research Paper (undergraduate), 2006

70 Pages, Grade: 1,7

S. Volker (Author)


Excerpt

Table of contents

List of figures

List of abbreviations

List of symbols

1. Introduction
1.1. Description of the problem
1.2. Objective of the work
1.3. Scope of work

2. Risk Management and derivatives: Theoretical background
2.1. Risk Management
2.1.1. Definition of Risk
2.1.2. Necessity of Risk Management
2.2. Derivatives
2.2.1. Characteristics and functionality
2.2.2. Types of derivatives
2.2.2.1. Forwards and Futures
2.2.2.2. Options
2.2.2.3. Swaps
2.2.2.4. Caps, Floors and Collars
2.2.3. Actors in the market
2.2.3.1. Hedgers
2.2.3.2. Speculators
2.2.3.2. Arbitrageurs

3. Weather derivatives
3.1. Definition and differentiation
3.2. Evolution
3.3. Field of application
3.3.1. Companies and public institutions
3.3.2. Financial institutions
3.3.3. Investors
3.4. Structure
3.5. Underlying
3.5.1. Temperature
3.5.2. Precipitation
3.5.3. Wind
3.6. Methods of valuation
3.6.1. Black & Scholes
3.6.2. Burn-Analysis
3.6.3. Monte-Carlo-Simulation
3.6.4. Stochastic models
3.7. Problems in application
3.7.1. Pricing
3.7.2. Legal and fiscal formalities
3.7.3. Regulation of markets

4. Example of use
4.1. Contract parties
4.2. Contract parameters
4.3. Outcome
4.4. Other examples

5. Summary and outlook

Appendix

Bibliography

List of figures

Figure 1: Systematisation of risks

Figure 2: Weather influence on different branches

Figure 3: Reasons for risk management

Figure 4: Forward and future payoffs

Figure 5: Win / loss - profile of a European call option

Figure 6: Win / loss - profile of a European put option

Figure 7: Development of the notional value of weather derivatives

Figure 8: OTC contracts by region

Figure 9: Stock exchange trade versus OTC trade

Figure 10: Correlation temperature and other assets

Figure 11: Example of weather contract data

Figure 12: Weather indexes

Figure 13: Common term operations

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

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

Figure 16: Wind derivative construction

Figure 17: Steps of Burn Analysis

Figure 18: Assessment of traditional derivative pricing models

Figure 19: Index Value Simulation and Daily Simulation Method

Figure 20: Contract parameters of Safari-Land weather derivative

Figure 21: Payoff situation for Safari Land

List of abbreviations

Abbildung in dieser Leseprobe nicht enthalten

Abbildung in dieser Leseprobe nicht enthalten

List of symbols

Abbildung in dieser Leseprobe nicht enthalten

1. Introduction

“Everybody talks about the weather but nobody does anything about it” Mark Twain, 19. century

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.4It 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 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.6Facing 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 in- strument.

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 de- picted critically.

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:

Abbildung in dieser Leseprobe nicht enthalten11

“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”.12This 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 prac- tice. 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 evalua- tion should be performed, regarding potential loss frequency and severity of the 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 advan- tage fails to occur.21Or 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:

Abbildung in dieser Leseprobe nicht enthalten

Figure 1: Systematisation of risks24

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:

Abbildung in dieser Leseprobe nicht enthalten

Figure 2: Weather influence on different branches26

2.1.2. Necessity of Risk Management

As a consequence of globalisation and liberalisation, the competition that compa- nies are facing today becomes more and more intense. One milestone in the de- 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 com- plex, 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 conti- nuity 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:

Abbildung in dieser Leseprobe nicht enthalten

Figure 3: Reasons for risk management31

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 com- pany 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.32Theoretically, any asset could be the subject of a derivative.33In 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 for example an active trading in credit derivatives, insurance derivatives and weather derivatives.35

Derivatives play an important role in the risk management. In these days derivatives are an indispensable tool allowing to shed nearly all kind of unwanted risks.36As the classic derivatives just cover the price risks of the underlying asset, weather derivatives can be used to mitigate volumetric risks in demand and supply caused by adverse weather conditions.37

Derivatives cannot be reduced to their ability to hedge risks. Beside hedging risks, derivatives are added to bond issues, used in executive compensation plans, embedded in capital investment opportunities, and so on.38

The most important types of derivatives are outlined in the following chapter.

2.2.2. Types of derivatives

2.2.2.1. Forwards and Futures

The forward contract is an obliging agreement to buy or to sell an asset at a certain future time for a certain price. The party who agrees to buy the underlying asset on the predetermined conditions assumes a long position. The counterparty, who agrees to sell the asset, assumes a short position.

Forward contracts are the oldest type of derivatives and the construction of these instruments is quite simple.39They are broadly applied, especially in the foreign exchange market in order to hedge foreign currency risks.40

Forward contracts are not standardized, so the contract details are to be negotiated individually between the involved parties. They are traded in the over-the-counter market.41This procedure bears the risk that the contract partner could violate the contract, for example because of insolvency.

Futures are a further development of forward contracts.42The basic concept also is to agree on the purchase or on the selling of an underlying asset at a certain future time for a certain price. In difference to the forward contract, futures are standard- ized contracts being traded on an exchange. The exchange provides a special system ensuring that the obligation between the contract partners will be honored. On the one hand, this system stipulates a daily settlement of the interrelated payments. On the other hand, every contract partner has to deposit a special security, called additional margin, on a margin account. These regulations reduce the settlement risk for the contract partners.43

The following chart shows the payoffs resulting from forward and future contracts:

Abbildung in dieser Leseprobe nicht enthalten

Figure 4: Forward and future payoffs

The investor assuming a long position profits from an increasing price of the underlying asset whereas the investor in a short position gains profits if the price of the underlying asset declines.

The chart shows a positive occurrence probability of unlimited wins or losses for both parties which means a symmetric risk-profile.44

In difference to forward contracts, future contracts are usually closed before the delivery or maturity date. There is a cash settlement between the two parties and the underlying asset is not physically delivered.45

2.2.2.2. Options

By signing (buying) an option, the owner is given the right but not the obligation, to buy (call option) or to sell (put option) a stated number of the underlying asset at a predetermined price (strike price).46For this right, the buyer of an option pays an initial cash amount to the seller of the option.47

It has to be distinguished between the American option and European option. The American option can be exercised at any time up to the date the option expires whereas the European option can only be exercised at the maturity date.48 For there are two sides of every option contract (buyer and seller), the following four positions can be adopted:49

- Long call: The buyer of a call option is given the right to buy a fixed number of the underlying asset at the strike price. For this right, he pays cash up front to the seller of the option.
-Short call: The seller, also called the writer, of a call options receives the upfront payment for the obligation to deliver a stated number of the underlying asset for the strike price.
- Long put: By signing a put option, the buyer is entitled to sell a stated number of the underlying asset for the preetermined strike price. He also pays an initial premium to the seller of the put.
- Short put: The opposite position of the long put position bounding to buy a stated number of the underlying asset for the strike price. For this obligation, the seller receives cash up front from the buyer of that option.

Assuming a long position means having the right to buy or to sell the underlying asset whereas the party in the short position is obliged to buy or to sell the under- lying asset.50

The following chart shows the win/loss - profile of a European call option:

Abbildung in dieser Leseprobe nicht enthalten

Figure 5: Win / loss - profile of a European call option51

As depicted, the buyer of a call option profits from an increasing price of the underlying asset.

He is going to exercise his option at the maturity date if the price of the underlying asset exceeds the strike price “K”. The net profit resulting from his position can be described as (all calculations neglect transaction costs):

Abbildung in dieser Leseprobe nicht enthalten

The Beak-Even-Point of the long position is: BE = K + C.

The maximum profit of a long call position is unlimited; the maximum loss is limited to the price paid for the option “C” for the purchaser will not exercise his right if the actual price of the underlying does not exceed the strike price. The option expires worthless.52

The seller’s profit or loss is the reverse of that for the buyer of the option.53

Unless the price of the underlying asset does not exceed the strike price, the option will not be exercised and expires worthless. In that case, the profit of the seller is the received option price “C”. If the price of the underlying exceeds the strike price on maturity date, the buyer will exercise the option. In that moment, the writer is obliged to deliver the underlying for the strike price which means gaining losses as follows:

Abbildung in dieser Leseprobe nicht enthalten

The maximum profit of a short call position is limited to the received option price whereas the possible losses are unlimited.54

The Beak-Even-Point is also: BE = K + C.

The win / loss - profile of a European put option is shown in the following chart:

Abbildung in dieser Leseprobe nicht enthalten

Figure 6: Win / loss - profile of a European put option55

The purchaser of a put option profits from a decreasing price of the underlying asset. He is going to exercise the option if the price of the underlying on maturity date does not exceed the strike price. The resulting positive cash flow is:

Abbildung in dieser Leseprobe nicht enthalten

The Break-Even-Point is: BE = K - C.

By assuming a long put position, the maximum profit of the investor is unlimited. The maximum loss is limited to the option price paid, because the option expires worthless if the price of the underlying asset exceeds the strike price.56

The payoff situation of the seller of the put option is again exactly the reverse. The maximum profit is limited to the option price received and the possible losses are unlimited.57If the option is exercised because of the price of the underlying does not exceed the strike price, the seller has to buy the underlying asset for the strike price from the purchaser of the option.

The resulting loss can be calculated as follows:

Abbildung in dieser Leseprobe nicht enthalten

Options are traded over-the-counter and on exchange trades.58Exchange trades, such as EUREX or LIFFE, offer standardized products. These homogeneous products and professional market makers ensure a high liquidity of the market. The exchange guarantees that the contracts will be honored and therefore the chief potential disadvantage of the over-the-counter-market, the potential default of the contract partner, does not play a role.59

[...]


1See Auer, J. (2003), p. 1.

2Clemmons, L. (1998), p. 997

3See Wirth, B. (2004), p. 1.

4 See Considine, G. (2000), p. 1.

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

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

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

8 Maier, G. (2001) (without page)

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

10See Jolly, A. (2003), p. 146.

11 See Jolly, A. (2003), p. 148

12Jolly, A. (2003), p. 148

13See Jolly, A. (2003), p. 148.

14See Bitz, H. (2000), p. 16;39.

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

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

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

18For the Steps, see for example Treischmann, J. et al. (2005), p. 12.

19McLaney, E.J. (2000), p. 13.

20See KPMG (2000), p. 1.

21See Gabler Wirtschaftslexikon on CD-ROM.

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

23 See Jolly, A. (2003), p. 145.

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

25 See Becker/ Hörter (1998), p. 694.

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

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

28See Ong, M. (2006), p. 4.

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

30 See AktG § 93.

31Own presentation with ref. to: M_O_R Management of risks: Guidance for Practitioners, p. 8.

32See Hull, J. (2006), p.1.

33See McLaney, E.J. (2000), p. 12.

34 See Neftci, S.(2000) p. 2.

35See Hull, J. (2006), p.1.

36See Ellithorpe (1999), p. 166.

37See Cao, M., Li, A., Wei, J. (2004): The Journal of Alternative Investment, p. 93.

38See Hull, J. (2006), p.1.

39See Deutsch, H.-P. (2001), p. 56.

40See Hull, J. (2006), p.4.

41See Hull, J. (2006), p. 4.

42 See Deutsch, H.-P. (2001), p. 57.

43See Rudolph, B., Schäfer, K. (2005), p. 56.

44See Rudolph, B., Schäfer, K. (2005), p. 23.

45 See Hull, J. (2006); p. 42 f..

46See McLaney, E.J. (2000), p. 223.

47See Rudolph, B., Schäfer, K. (2005), p. 19.

48See Black, F., Scholes, M. (1973), p. 637.

49See Hull, J. (2006), p. 183.

50 See Deutsch, H.-P. (2001), p. 59.

51Own presentation

52See Rudolph, B., Schäfer, K. (2005), p. 19.

53 See Hull (2006), p. 183.

54See Rudolph, B., Schäfer, K. (2005), p. 21.

55 Own presentation

56See Hull (2006), p. 185.

57See Rudolph, B., Schäfer, K. (2005), p. 21.

58See Deutsch, H.-P. (2001), p. 58.

59 See Rudolph, B., Schäfer, K. (2005), p. 27.

Excerpt out of 70 pages

Details

Title
Weather derivatives
Subtitle
The effects of weather catastrophies on economy
College
University of Applied Sciences Essen
Course
Case study in the core subject International Management - Risk Management
Grade
1,7
Authors
Year
2006
Pages
70
Catalog Number
V62647
ISBN (eBook)
9783638558549
ISBN (Book)
9783638710022
File size
2193 KB
Language
English
Tags
Weather, Case, International, Management, Risk, Management
Quote paper
S. Volker (Author)S. Maybauer (Author)M. Boensch (Author), 2006, Weather derivatives, Munich, GRIN Verlag, https://www.grin.com/document/62647

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