WEATHER Derivatives

                          Weather Derivatives
WEATHER Derivatives
suggest that the number of contracts traded will be      more in the market. It is difficult to quanti...
WEATHER Derivatives
                                 Investment buyers of weather derivatives will tend     ingful perform...
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Alternatives Jun 08 - Weather derivatives - UBS Global Warming Index - Murisic


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UBS Global Warming Index (Ilija Murisic)

Keywords: Weather, HDD, CDD, CME, futures, climate change, Index ,Kyoto, UBS, derivatives, hybrids, trading, structured products

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Alternatives Jun 08 - Weather derivatives - UBS Global Warming Index - Murisic

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