Weather Derivatives AgBiz Insurance Workshop 08 October 2015 Raphael N. Karuaihe, PhD
Need for Weather Derivatives Weather conditions tend to affect volume and usage more than they directly affect the price, but volume and usage directly affect the price. Although the prices may change as a consequence of unusually high or low demand or supply, price adjustments don't necessarily compensate for lost revenues resulting from unseasonable weather.
Weather Impacts Volume PRICE x VOLUME = REVENUE PRICE RISK MANAGEMENT + WEATHER RISK MANAGEMENT LOWER EARNINGS VOLATILITY 4
Weather parameters as a commodity Insurance has been the main tool used by companies and farmers for protection against unexpected weather conditions. But insurance provides protection only against catastrophic damage. Insurance does not protect against the reduced demand and revenue that businesses experience as a result of weather. Weather derivatives cover low-risk, high-probability events. Weather insurance, on the other hand, typically covers high-risk, low-probability events, as defined in a highly tailored, or customized, policy. Insurance has to be taken before the risk period starts 5
Who buys weather risk management products? Agricult ure Const ruct ion Energy Ent ert ainment Government s Insurance Manuf act uring Ret ail ing T rans port at ion Crop yield, handling, st orage, pest s Del ays, incent ive/ disincent ive clauses Reduced and/ or excessive demand Post ponement s, reduced at t endance Budget overruns Increased claims, premium diversif icat ion Reduced demand, increased raw mat erial cost s Reduced demand of weat her-sensit ive product s Budget overruns, delays
Typical Weather Futures and Options Futures: It s a type of weather derivative that obligates the buyer to purchase the value of the underlying weather index measured in rain index (RI), high degree days (HDD) or low degree days (LDD) at a future date. Options: Exchange traded options where the value is determined by using the underlying weather futures. In OTC options value can be determined using actual and forecasted weather data.
Need for Weather Futures Weather influences our daily lives and choices, and has an enormous impact on corporate revenues and earnings. Agriculture, energy, entertainment, construction, travel and others sectors The SAIA (South African Insurance Association) and IISA (Insurance Institute of South Africa) report to have given R 1 billion insurance claims for massive damage due to extreme weather events during 2013-14, with actual losses more than over R 1.5 billion in agriculture sector. Weather futures are necessary for price discovery in the weather market and it forms the basis for other exchange traded products
Need for Weather Options Better capture the requirements of a set of customers Floated at the behest of large customers and others chip in Need a liquid weather future market for reference
Weather Futures and Options - CME In 1999, the Chicago Mercantile Exchange (CME) took weather derivatives a step further and introduced exchange-traded weather futures and options on futures - the first products of their kind. CME weather futures and options on futures are standardized contracts traded publicly on the open market in an electronic auction-like environment, with continuous negotiation of prices and complete price transparency. CME weather futures and options on futures are exchange-traded derivatives that - by means of specific indexes - reflect monthly and seasonal average temperatures of 15 U.S. and five European cities. These derivatives are legally binding agreements made between two parties, and settled in cash. Each contract is based on the final monthly or seasonal index. Weather futures volume is currently over 634,000 and has increased 10% yearly. Open Interest has reached 349,000 and Notional value has surpassed $50 billion. Indices are HDD, CDD/CAT
Weather Options - OTC Crop Location Settlement Station Grapes Groblershoop Upington Airport Cold Degree Day Index Definition Date From Date to Daily Minimum temperature below the strike 1-Sep-14 15-Oct-14 Strike 1 4 C Strike 2 3 C Strike 3 2 C Notional 1 (ZAR/ C) 4000 Notional 2 (ZAR/ C) 6000 Notional 3 (ZAR/ C) 40000 Total Sum Insured (ZAR) 1,000,000 Maximum Payoff (ZAR) 520800 Average Payoff (ZAR) 69364 Premium (ZAR) 90,000
Weather Derivatives for SA Crop Area Distribution - Maize
Maize Growing Regions and Weather Stations
Ideal Weather Parameter Rainfall plays a major role in production of Maize. From many studies, it is found that precipitation increase had a positive effect and decrease had a negative effect on net revenue. Example: Rain Index for Maize Crop Rain Index and Crop yield at various locations over the years in Free State Province (Correlation 0.7)
Rainfall Index and Price of Crop
Rainfall Index Futures Location : Bloemfontein Rainfall Index Symbol BLOEMRAIN Contract Available for Trading Trading period 1 st November to 31 st March Trading session Mondays to Fridays 9:00 am to 5:00 pm Trading Trading Unit (one lot size) 600 ( times of Rainfall Index ) Rainfall Index Definition Rainfall index defined as sum of cumulative daily rainfall for the contract period. Quotation/ Base value 600 times 355 R ( 355 is the normal rainfall in the contract period) Maximum order size 100 contracts (1 contract = 600 times of Rainfall INDEX) Tick size (minimum price movement) R 600 Daily price limits 9 % Initial Margin 20100 R (@ 10% of the expected unit contract value i.e. 600*355) Special Margin Maximum Allowable open position Client level Maximum Allowable Open Position Member level In case of additional volatility, a special margin at such percentage, as deemed fit, will be imposed immediately on both buy and sale side in respect of all outstanding position, which will remain in force for next 3 days, after which the special margin will be relaxed To be decided 25% of the open market position
Daily Settlement Procedure Tier 1: JSE market data The baseline for the settlement is the price of the last trade that occurs on JSE as of the snapshot time, a randomly selected time between 15:00 and 15:15 Central Time (CT). The last trade must have at least 10 lots in order for its price to be used as the baseline. Tier 2: Absence of market data In the absence of market data, a contract settles to the prior-day price. Tie 3: Within the accumulation period A contract in the accumulation period may be adjusted to the actual daily accumulation of heating degrees plus the 10-year average of heating degrees for each of the days remaining of the period. The heating degrees for a given day are the total number of degrees that the average outside air temperature drops below the base temperature of 65 F (or 18 C for non-u.s. cities).
Settlement Data Weather data will be captured at the sites from which historical data is required Equipment as per WMO standards Back up stations defined to provide back up data Hourly Data will be provided at a 6-12 hour lag A panel of Meteorologists will monitor data Cross check against satellite, surrounding stations, other parameters Procedure will be given on JSE s site
Where to from here? FSB JSE Legal Council to make a case for weather derivatives to be recognized as security; Recognize weather derivatives as security. Pilot Projects Weather OTC transactions, cleared on the JSE Exchange traded products Weather futures and Options Education, education, education
THANK YOU! Tel: (011) 520 7039 Email: commodities@jse.co.za;