Do you know what a shield is against fickle weather?
Yes, we are talking about Weather Derivatives
Before we dive into what this scary-sounding topic means, let us first understand what are
Derivatives. Fret not non-engineers! These are not the derivatives that are taught to us since
our junior colleges.
SO, WHAT ACTUALLY IS A DERIVATIVE?
A financial derivative is a financial contract that derives its value from an underlying asset
such as stocks, indexes, commodities or even measurable events such as weather. In simpler
terms, it is a product that derives its value from some other product.
For example– Suppose you pre-book an expensive limited-edition car for Rs. 1 lakh but then
change your decision so you go on and sell that booking for Rs. 1,25,000 to another person
who was interested in buying the same car but missed out on the opportunity. This is what
derivative trading essentially means, trading a contract to a commodity but not the
USES OF DERIVATIVES
Derivatives are used for multiple purposes, the primary reason being hedging, increasing
exposure to price movements for speculation or being able to trade assets that are hard to get
physical access to. One example of such derivatives, the crux of the 2008 financial crisis, is
the credit default swaps. A credit default swap is an agreement in which the seller of the swap
will compensate the buyer in the event of a debt default by the debtor. To put it simply, the
seller of the credit default swap insures the buyer against the default of the underlying asset.
A Deeper Dive into Weather Derivatives
Companies that are directly and heavily dependent on agriculture such as DuPont India take
certain measures to mitigate the risks related to excess or lack of rainfall in a given year.
This is where Weather Derivatives come into the picture. DuPont India can use Weather
derivatives to hedge against the risk of weather-related losses. Even with our advanced
technology-based society, farmers are still at the mercy of the weather. In 2018, agriculture
contributed about 17-18% to the GDP of India and employed over 50% of the total
workforce. Agriculture, tourism, travel and energy are just some sectors of the economy that
depend on the whims of weather and can be negatively impacted by extreme or inclement
How did such an exotic financial instrument evolve?
During the mid-’90s, investors in the United States created a weather index based on monthly and seasonal average temperatures and began trading weather.
Companies whose business depends upon the weather such as energy business or those who manage sporting events use weather derivatives as a part of the risk management strategy. The risks businesses face due to weather are unique in that they cannot be controlled and are highly specific from region-to-region. Weather conditions affect the volume and usage of the particular good or service more than the price of that commodity. For example, a disproportionately warm winter can leave energy companies with an excess of oil and natural gas.
Typically, weather derivatives are attached to an index that measures a particular aspect of weather like total rainfall over a specific period and a specific place. In 1999, the Chicago Mercantile Exchange introduced the first exchange-traded weather futures and options on futures, the first of their kind. These futures and options traded publicly in the open market in an electronic-auction environment with complete price transparency and on-going negotiations as compared to being private and individual agreements between two parties.
Let us understand the difference between Weather Derivatives and Insurance against Weather?
Weather derivatives and insurance against weather are similar in nature but derivatives cover a wider range of risks as compared to insurance. For example, insurance would only cover low-risk, low-probability catastrophic weather events such as hurricanes, earthquakes, etc. Derivatives, on the other hand, cover high-probability events such as warmer than expected winter, dryer than expected monsoon.
Insurance would not cover a slump in demand due to a slightly colder summer whereas weather derivatives would. It would probably be in the interest of companies to purchase both since they collectively cover and protect against a wider range of possibilities.
But why do Indian markets require weather derivatives?
India has always faced unpredictable monsoons. Non-seasonal adverse weather conditions spoil the harvest for farmers too. With the unpredictable nature of weather conditions, a few people advocate the importance of launching derivative products based on rainfall, temperature, moisture and wind among others to help farmers, with corporates hedging against these risks.
For example, ITC, when sourcing agricultural commodities, can use these derivative contracts to minimize the effect of the fluctuations in the prices.
What goes behind the pricing?
A degree day is a temperature-based measurement calculated as the deviation of the average daily temperature from a pre-defined base temperature. The standard pre-defined base or ideal temperature is 65˚ F or 18˚ C, as at temperatures below 18˚ C.
HDD (Heating degree days) measures how many degrees a day’s average was below the defined baseline temperature (65˚ F) and CDD (Cooling degree days) measures how many degrees a day’s average was above the defined baseline temperature (65˚ F.)
For example, if the baseline temperature is 65˚ F and the day’s average temperature is 30˚ F, the HDD will be 35 points and the CDD will be 0. Similarly, if the average temperature is 85˚F, the CDD will be 20 and HDD will be 0. These contracts are valued each day or month by multiplying the HDD or CDD value by $20. According to the example, the HDD will be valued at 700$ and CDD at 0$ in the first case and HDD at 0$ and CDD at 400$ in the second case.
Now, let us see how can one make money out of these contracts. If you expect that the average temperature will be lower than the existing 30˚ F and will be at 28˚ F you buy the HDD contract at 700$ (30˚F) and sell it at 740$(28˚F).
How is India reacting to this?
The Securities Exchange Board of India is examining the feasibility of allowing derivative contracts based on weather and freight in the Indian commodity segment. As the name suggests, every derivative instrument has an underlying asset based on which its price is determined but this is not the case with the weather derivative. Therefore, the SEBI panel is analysing the pricing models. Some media reports suggest that SEBI has asked commodity exchanges to work on various parameters to evolve a standard product, based on temperature and rainfall, besides region-specific factors.
Attempts in history in India to launch the weather derivative
Given the possible benefits, has anybody attempted to launch the weather derivative? The National Commodity and Derivatives Exchange (NCDEX) has been planning to launch weather futures, from as far back as 2003. It was even working on a rain index, a tool to track the monsoon’s progress, jointly with the Indian Meteorological Department. However, it could not make much headway, as knowledge about derivative products was very poor at that time.
Weather risk affects farmers, during both pre- and post-monsoon periods. It has a significant direct and indirect economic impact across sectors, such as insurance, FMCG, tourism and even sports.
Indian exchanges should introduce derivatives on weather, to help farmers, consumers, corporates and insurance companies hedge against weather risks. Consumers will benefit from lower volatility of the product prices. Corporates will benefit from stable procurement costs and revenue realization. Insurance companies will be able to manage their crop insurance segment better using this financial instrument.
The product will taste real success if the data is easily and quickly available across the country and is cost-effective. Educating farmers about the benefits of the product will be a critical aspect to make this product a real success.
After the weather settles
There are many challenges to effective use, implementation and management of weather derivatives and options. Weather derivatives can be very useful to risk managers who understand options and risk profiles associated with buying and selling weather options relative to their business. There is a range of concerning complications, however, considering the weather conditions in India and effects on various stakeholders, the time has come to add one fancier financial product to exchange’s bouquet of offerings.