WEATHER Derivatives
Weather Derivatives
Cherry Reynard reports on the
latest hot product to change the
derivative landscape
According to the Chicago Mercantile Exchange,
weather has an impact on revenues for around 30%
of the US economy. For many companies, this is
higher than foreign exchange risk or other types of
risk that are widely hedged. With the impact of cli-
mate change making weather conditions more
unpredictable, the business risk from weather looks
set to rise. Yet, the majority of companies do not
hedge against the weather and weather derivatives
remain a young and relatively immature market. Is
this likely to change as climate change becomes
more potent?
The first widely-known weather derivatives deal was
completed between fallen energy behemoth Enron
and Koch Energy in 1997. It was structured around
temperature conditions: Like a spread betting deal,
Enron would pay Koch $10,000 for every degree the
temperature fell below a set level, while Koch would
pay the same for every degree above it.
34 ALTERNATIVES
It was picked up by energy companies who found
that fluctuations in weather were hampering their
ability to deliver steady earnings to investors. Peter
Brewer, chief investment officer of Cumulus Funds,
says: “It came down to people would use gas if it
was cold to heat things up and electricity if it was
hot to cool things down. The contract would pay
money out if the temperature changed.”
Insurance companies then became involved, who
saw it as a means to move risk around. In 1999, the
Chicago Mercantile Exchange (CME) began to list
temperature futures. These were vanilla contracts
based on the temperature in certain cities on certain
days. Brewer says that this was an attempt to turn
what had been an over-the-counter market into an
exchange-traded one, but it generated little interest
from any of the market participants at the time.
The implosion of Enron in late 2001 caused consid-
erable dislocation in this nascent market. It had been
the biggest player and the market was left with a dis-
parate bunch of investors and traders, which includ-
ed some insurers, some banks and some energy
companies. But Enron employees started to move
into the insurance groups and banks and resume
trading there.
Brewer says: “It really started to happen post-
Enron. There was more focus on counterparty risk.
The Chicago Mercantile Exchange removed that
credit risk and began to pick up a lot more business.
By 2002, it had a 90% share of trading activity in
weather derivatives.”
The weather derivatives market now splits neatly
into two main areas: There is the secondary market,
which trades on the CME and then there is the more
esoteric off-exchange market, which allows for more
structured deals. According to statistics from the
Weather Risk Management Association (WRMA),
around 730,087 derivatives contracts were traded
from April 06 to March 07. This was down on the
previous year when hurricanes Katrina and Rita
increased the appeal of hedging weather risk and
over one million contracts were traded. Hurricane
Katrina, in particular, proved one of the most cost-
ly in US history, with estimates of damages around
USD65bn.
Volumes on weather conditions in the US were
largely stable, while European contracts declined.
However, the WMRA said that it was seeing rapid
underlying growth in the weather business in other
regions of the world, notably India, which are yet to
be captured in the survey. The WRMA says that
early indications for the 2007/2008 survey period

suggest that the number of contracts traded will be
nearer the 2005/2006 figures. If catastrophic weath-
er conditions continue to be a predictor of trading
volumes (as they have been in the past), then
2008/2009 is likely to be even stronger, encompass-
ing the earthquake in China, cyclone in Burma and
further hurricanes in the mid-West of the US.
For the exchange-traded market on the CME, the
main volume is in contracts on heating degree days
(HDD) and cooling degree days (CDD) on 18 cities
around the world. Temperature contracts accounted
for volumes of USD18.9bn in 2006/2007. Although
much of the trading is in US cities, CME offers
futures on temperatures in Amsterdam, Barcelona,
Berlin, London, Madrid, Paris, Rome and
Stockholm. These are well-traded, liquid contracts
and are mostly traded by energy companies, funds
(including hedge funds) and insurance companies.
The presence of large energy companies means
most arbitrage opportunities quickly disappear.
The CME has tried to expand its range recently,
finding that demand for weather hedging goes
beyond temperature. As such, it has introduced
products focused on frost, snowfall, rainfall and
even a hurricane future. However, trading in these
areas remains relatively limited with rain and wind
contracts attracting volumes of just USD142 million
and USD36 million respectively in 2006/2007.
The key problem for the CME in developing new
products remains access to quality data. Eric Gisiger
a member of the investment committee of Man
ECO says that few companies actually understand
the impact the weather has on their bottom line. He
adds: “They know they might get depressed results
due to poor weather conditions , but have less of
an idea how much is attributable to the weather and
therefore how much they need to hedge. Available
standardised weather contracts such as the ones
traded on the CME could be used but usually have a
basis risk, in other words do not perfectly hedge the
underlying risk.”
He believes that although these contracts are use-
ful, they can only ever represent standardised
hedges. There is therefore a basis risk. The weather
in central London is not necessarily the same as in
Heathrow and therefore the standard products do
not always reflect the exact market risk.
The off-exchange weather derivatives are only
marginally captured by the WRMA statistics.
Examples of this type of contract could be whether
it is going to rain at a sporting event or whether it
will snow in Meribel this season. Stephen Doherty,
chief executive officer at Speedwell Weather, says:
“These more exotic structures will be based on the
fair value for the trade plus a profit margin for tak-
ing the risk. These products are unlikely to trade
thereafter.”
These tend to be smaller volume trades, but there are
WEATHER Derivatives
more in the market. It is difficult to quantify the
exact size of the market as there is no centralised
data point, but it is thought that this market is now
much larger than the exchange-traded market.
Catastrophe, or "cat" bonds are also a growing
area. These are issued by insurance companies and
designed to cover particular risks. Investors will buy
on the assumption that an event won't happen. If
the event happens, the investors lose their money
and the insurance company makes enough money to
cover a proportion of the money it has to pay out to
its clients. These bonds are also being picked up by
hedge funds in a blurring of the lines between insur-
ers and weather derivatives investors. Traditional
'catastrophic' events have been seen as the domain of
the insurers alone.
The corporate users of these products are dis-
parate. For example, the CME launched snowfall
futures and hurricane futures primarily to help state
governments manage their budgets. In addition to
energy companies, beverage producers are subject to
the vagaries of the weather - Britvic, for example,
made several references to its vulnerability to weath-
er conditions in its recent results statement.
Construction projects can be influenced by the
weather as can ski resorts and other holiday groups.
Retailers are often affected by high rainfall and poor
conditions as people don't tend to go out shopping.
On the other hand, WH Smith benefited from last
year's terrible weather because people stayed inside
and read books.
San Francisco-based WeatherBill has just pub-
lished a study identifying the relationship between
weather conditions and flight disruptions. It showed
that 14% of the 21 million flights evaluated in the
study were delayed or cancelled due to
weather. More than 25% of all flights “This market is still
studied were cancelled or delayed of
which 55% of those disruptions (3 mil-
very immature and
lion flights) were weather-related. Thestill very opaque,
survey showed some airports such as San
Francisco, Reno and Chicago's O'Hare
that's why hedge
suffered disproportionately from weath-funds like it”
er-related delays.
These corporate will use the basic con-
tracts available to them on the CME and Stephen Doherty,
also structure their own deals if they
need more tailored, specific hedging.
chief executive officer
They need to make sure that this type of at Speedwell Weather
hedging is cheaper than insurance.
Doherty says that some of the most complex deals
are now within agriculture. This has felt the early
effects of climate change most significantly with
crop destroyed by poor weather conditions. He adds:
“There has been an explosion in this area. Weather
conditions affect crops - including rain and temper-
ature. Timing is also important. You are seeing some
exotic weather structures in this area.”
ALTERNATIVES MAGAZINE 35
WEATHER Derivatives
Investment buyers of weather derivatives will tend
to be standard investors such as pension funds and
asset managers looking for a non-correlated asset
class. This is where UBS has seen most demand com-
ing for its Global Warming index (see box-out).
Gisiger says that hedge funds active in the space also
look at the non-exchange traded , insurance market.
He says: “This market is still very premature and
opaque, a key reason why hedge funds like it. The
bespoke insurance market is bigger and more attrac-
tive in terms of potential margins to be earned but
also requires a specific skill set rarely available.
Market participants assume that a lot of the hedge
fund money goes into the bespoke deals, though
there are hedge funds actively trading through CME
contracts. ”
There are a number of specific weather funds
investing in the derivatives market. Brewer runs the
Cumulus Climate fund, which launched in February,
and has a technical, quantitative-driven approach.
The fund is a long-short equity fund which seeks to
profit from the financial impacts of climate change.
It has not been running long enough to deliver mean-
The UBS Global Warming index
The UBS Global Warming index (UBS-GWI) is the only index that currently
exists for the weather derivatives markets.The index grew out of demand
from multi-asset clients for new uncorrelated assets. Ilija Murisic, Executive
Director, Hybrid Derivatives Trading at UBS says: “In 2007, the equity and
commodity markets had rallied and investors were looking for asset classes
that were truly uncorrelated.We started to look at weather derivatives and
thought they were a very interesting market.There was empirically no corre-
lation with equities.”
The UBS-GWI was launched in May last year and is constructed using the
Heating Degree Day (HDD) and Cooling Degree Day (CDD) weather
futures contracts traded on the CME.The index is currently composed of
weather futures contracts on 15 U.S. cities.To be eligible for inclusion, the
volume of futures traded for any given city must represent 1% or more of
the total weather derivatives contracts traded on the CME. At the moment,
futures on New York weather form the largest part of the index at 31%.
Cities from Europe and Asia are expected to become part of the index in the
medium term.
The UBS-GWI Governance committee meets annually in September to revis-
it the weightings of the index and its sub-indices family (currently composed
of four US regions: Northeast, Midwest,West and South).
Since launching this index, UBS has moved into similar areas, launching carbon
trading, energy, commodities and freight indices. Murisic believes there is
good potential growth in these markets, pointing out that the weather deriva-
tives market has grown from $2.2bn in 2004 to around $40bn in 2007.
Murisic says that although the underlying instruments are complex, the index
itself is designed to be very simply and trade like the S&P index. Investors
don't need to look at seasonal variations.The index performance has moved
from around 100 at launch to around 250 today.
Investors have been varied. Murisic says: “We have had a lot of interest from
insurance companies. Many of our investors come from Europe, particularly
Scandinavia and from Asia. Hedge funds have not been a big buyer, but there
has been a lot of interest from wealthy private individuals. Asset managers
and pension funds use the asset class to diversify - they have an allocation to
alternatives and they put some of it into weather.” In general, he believes that
interest has not come from specialist weather funds and weather investors,
but more from normal investors looking for diversification.
36 ALTERNATIVES
ingful performance statistics, but Brewer says that it
has been run on a formal 'paper trading' basis for 16
months and delivered annualised returns of over
15% to end-December despite considerable volatility.
It targets 15-20% returns on 10% volatility.
The Nimbus fund, based in Bermuda and run by
Nephila has also proved popular. The Nephila spider
can apparently predict hurricanes, spinning its web
close to the ground when a hurricane is approaching
and high up in the shrubs and trees when the weath-
er is nice. The group has recently signed an agreement
to provide risk capacity and collateral to WeatherBill
to support weather contracts sold to customers.
There are also a number of more mainstream
weather-related investments launched in the retail
market such as the Schroders Climate Change fund
and the Virgin Climate Change fund. This demon-
strates that demand is there among retail investors for
this type of product, but so far these have been
entirely equity-based.
So how big is the weather derivatives market likely
to become? Doherty says: “The Enron idea that
weather derivatives will be as big as FX is not realis-
tic. Weather risk is important, but the market will
grow quietly. It will be resilient but unexciting. There
is a flexible and deep pool of capital and so far the
ability of the market to adapt and step up to the plate
has been surprising.” Hel believes there is ample
capacity in the market and it won't be constrained by
a lack of capital.
Gisiger says that at the moment corporate buyers
are restricted by the assumption that weather is sim-
ply a hazard of day-to-day business and therefore
does not need to be hedged in the same way as other
risks, though he believes more companies are becom-
ing aware of the options for hedging their weather
exposures.
Brewer concludes: “A lot of people said in the early
days that this could be the biggest business on the
planet. That's not something we would argue. This is
a specialist market for companies concerned about
the weather. It will grow, but we are not about to see
a doubling of volumes every year. That said, more
companies are becoming aware of the possibilities
and we are seeing more catastrophic weather condi-
tions.”
For the market to take off, there would have to be
increased shareholder pressure on corporates to
hedge out weather risk, plus an increased number of
investment buyers seeking uncorrelated returns. As
yet, there is little shareholder pressure, but corporate
are becoming aware of the potential of the weather
derivatives market and a growing number of buyers
are looking for new, alternative asset classes to hedge
out risk. Increased unpredictability of weather
conditions is also likely to stimulate demand. The
market is unlikely to see the sort of bullish partici-
pants it had in Enron, but should see steady growth
over the next few years. A