Pricing Weather Derivatives

SPRING 2000 T he impact of weather on business activities is enormous and varies both geographically and seasonally. For example, the 1982-1983 and 1997-1998 El Niño conditions were associated with warm winters in the eastern and midwestern U.S., resulting in significant energy cost savings for consumers and businesses. In addition, these conditions suppressed hurricane activities in the Atlantic and led to minimal economic losses due to hurricanes. However, the same weather pattern was also associated with extreme floods in California, resulting in both economic loss and loss of life. In general, almost all businesses, and in particular, the energy, property and casualty (re-)insurance, and agricultural industries, are either adversely or favorably affected by the weather. Faced with these challenges and opportunities, a new financial instrument — the weather derivative — has emerged in recent years (e.g., Jovin [1998]). Weather derivatives are structured as swap, call, and put contracts1 based on weather indexes. Commonly referenced weather indexes include, but are not limited to, heating degree day (HDD), cooling degree day (CDD), precipitation, and snowfall. For example, a major energy user can hedge the risk associated with lower-thanaverage winter temperatures by buying a winter HDD call. As another example, a snowmobile retailer can hedge against lowerthan-expected revenue by purchasing a snowfall put. The flexibility of defining weather indexes allows innovative structures to be developed using these instruments to manage a wide variety of weather-related risks. Sellers of weather derivatives usually include major energy companies which use the instruments to hedge their own risks and to make trading profits. Insurance and reinsurance companies are also important providers of capacity, as they look for alternative ways to deploy their capital. Although data limitations (due to the relatively short history of the weather derivative market) do not allow a thorough analysis of the correlation between weather derivatives and longer established financial instruments, it is widely perceived that the correlation is negligible. Thus, weather derivatives appeal to a wide array of investors as an uncorrelated asset class. These opportunities to trade on the weather also pose challenges for financial and risk management professionals (e.g., Kaminski [1998]; Stix [1998]), which include pricing, analysis, and portfolio management. First, the no-arbitrage option pricing model is not a practical pricing tool for weather derivatives because the underlying weather indexes are not traded instruments. Second, there also exist difficulties in implementing actuarial techniques for pricing, because the underlying weather indexes are non-stationary. Rather, they are characterized by long-term variations and trends with scales greater than the length of the historical record. In addition, Pricing Weather Derivatives