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The weather (derivatives) report. (End Analysis).

Weather derivatives have come a long way since 1997 when a handful of American energy companies developed several dozen over-the-counter (OTC) contracts. Weather derivatives are traded on the Chicago Mercantile Exchange (CME), the London International Financial Futures Exchange and the Helsinki Exchanges, with futures and options exchanges in other countries also seriously considering this innovation.

Although the notional value of contracts written in the past year was down $1 million from the previous year, from April 2002 through March 2003, the number of contracts transacted worldwide nearly tripled according to the Weather Risk Management Association. This amounts to 11,756 contracts with a value of nearly $4.2 billion.

Originally targeted toward utilities to enable them to hedge against unseasonable weather, these derivatives are now used by farmers, resorts, casinos, the travel industry, manufacturers of seasonal equipment, underwriters, reinsurers and any other sector with revenues subject to the vagaries of the weather.

Prior to the development of weather derivatives, businesses were unable to hedge against overall weather conditions. Some micro hedges existed, such as weather insurance (event insurance) and agricultural futures, but these are narrowly focused. Weather insurance hedges a narrow window of time, often one day. Agricultural futures hedge a tiny sector of the economy, such as soybeans. These micro hedges, even when aggregated, do not allow businesses to hedge against the risk of pervasively adverse weather conditions.

The impetus for the development of weather derivatives was the extremely warm winter of 1997 through 1998, when El Nino depressed the revenues of many utilities. An OTC market for weather options quickly emerged, but it proved ineffective due to lack of liquidity, an absence of price transparency and the ever-present risk of counterparty default.

This embryonic OTC market for weather derivatives languished until 2001 when the Chicago Mercantile Exchange introduced exchange-traded weather derivatives (both futures and options) which created the liquidity, price transparency and counterparty certainty that the market needed to be viable. Later in the same year, the London International Financial Futures Exchange introduced weather futures that now allow Europeans to hedge against their respective weather conditions. In 2002, the Helsinki Exchanges began trading weather futures to allow Scandinavian countries to hedge against their adverse weather conditions.

Currently, the weather derivatives market--which includes exchange-traded futures and options, as well as OTC contracts--is the fastest growing derivatives market in the world. In 2002, the CME alone traded $4.3 billion of weather derivative contracts. Although this amount is just a fraction of the multitrillion-dollar derivatives market, it represents remarkable growth considering that 2002 was the first full year that the CME offered such contracts.

What has caused such impressive growth? First, economists estimate that nearly 20 percent of the U.S. economy is directly or inversely affected by the weather. Such a percentage most likely applies to other developed economies, too, explaining the subsequent adoption of this contract by exchanges in England and Scandinavia.

Second, the exchanges are doing a good job of tooting their own horn. They heavily advertise this contract in applicable sectors so more and more firms are learning about and using this innovation. So far, ski lodges in the United States, pubs in the United Kingdom, restaurants and retail shops in Europe and golf courses in Japan have all used weather derivatives to hedge their revenues against the risk of adverse weather.

Finally, this growth is being fueled by new corporate governance codes, especially in the United States, which require companies to identify and hedge against foreseeable risks. Such regulation is especially applicable for utilities, which are publicly regulated.

Weather derivatives will continue to expand in Asia and Australia, as well as in the strongholds of Europe and the United States. This growth will likely develop from the latest movement toward smaller contracts, a broader spectrum of users and a diversification in the types of weather protection acquired.

Russ Ray, Ph.D., is professor of finance at the University of Louisville in Kentucky.
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Title Annotation:analysis of trading in weather derivatives
Author:Ray, Russ
Publication:Risk Management
Geographic Code:1USA
Date:Aug 1, 2003
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