## Weather Derivative Instruments

The most commonly traded instruments that are available in weather markets are weather-based call options, put options, and swaps. In weather-based call and put options, the firm seeking weather protection pays for a contract with an up-front premium. This company receives a payout if the average temperature over a given period of time (W) is either hotter or colder than the threshold temperature contracted for (S), depending on whether the buyer is seeking protection against mild winters or mild summers. For both calls and puts, the payments are keyed to the difference between the index and the strike level, depending on the contract arrangements.

In the case of call options, the seller pays the buyer when the weather index exceeds the specified (strike) level (W > S). The amount paid P is calculated by multiplying the difference between the realized weather index value W and the predetermined strike level S by the amount of payment to be made per unit of weather index (known as ''the tick'' k of the contract), or P = k(W-S). In the case of put options, payment is made to the end user only when the when the weather index is lower than the strike level (W < S), at the end of the contract, or P = k(S- W). Weather swaps, however, involve the two counterparties setting the strike over a given period and exchanging cash or assets, depending on the realized temperature (Ellisthorpe and Putnam 2000; Zeng 2000).

TABLE 8.1 Weather hedges using cumHDD put options and swaps

Type of Payout Revenue Revenue

Winter (W) cumHDD (S-W) [(S-W) x tick price] without hedge with hedge cumHDD PUT OPTION Mild 3,800

Strike (S) 4,000 Cold 4,200

cumHDD SWAP

Mild 3,800 200 \$12 million \$88 million \$100 million

Strike 4,000 0 \$0 \$100 million \$100 million

Cold 4,200 -200 -\$12 million \$112 million \$100 million

Source: MMC Securities. 2005. The Growing Appetite for Catastrophic Risk: The Catastrophe Bond Market at Year-End 2004. Available at www.guycarp.com/ portal/extranet/pdf/Cat%20Bond%20Update%20Final%20032805.pdf?vid=1.

200 \$12 million \$88 million \$100 million

0 \$0 \$100 million \$100 million

-200 \$0 \$112 million \$112 million

Table 8.1 offers a simplified example of weather hedging using a put option and a swap, with a strike cumHDD of 4,000 and a tick price of \$60,000. When the seasonal heating degree days are aggregated (cumHDD), the put option protects the company during a mild winter, while the company retains its sales advantage in the event of cold winters. When entering into a swap, however, the financial exposure is shared, leaving each party less exposed to the risk of adverse weather (Ellisthorpe and Putnam 2000). The reverse argument can be made using CDDs in a moderate summer, when less power is required for air conditioning. For a recent comparison between returns from hedged and unhedged portfolios, see Ameko (2004).