Weather derivative accounting

Weather derivative accounting – The weather has an enormous impact on business activities of many kinds and varies both geographically and seasonally. Sellers of weather derivatives use the instruments to hedge their own risks and to make trading profits. Just as a firm can manage its currency exposure, so it can hedge its weather exposure.

Contract concepts

A weather derivative is a contract between two parties that stipulates how payment will be exchanged between the parties, depending on certain meteorological conditions during the contract period. Weather derivatives are usually structured as swaps, futures and call or put options based on different underlying weather indices. Weather derivative accounting

Weather derivatives have one major difference from traditional derivatives. In contrast to traditional derivatives, there is no underlying traded instrument on which weather derivatives are based. Whereas equity, bonds or foreign exchange derivatives have their counterparts on the spot markets, weather is not traded as an underlying in a spot market.

This means that unlike other derivatives, weather derivatives are not used to hedge the price of the underlying, as the weather itself cannot be priced. They are used rather as a proxy to hedge against other risks affected by weather conditions, for example, the risk that heating oil consumption will decrease due to higher than normal temperatures.

A generic weather derivative contract can be formulated by specifying the following seven parameters: Weather derivative accounting

  • Contract type (swap, call or put); Weather derivative accounting
  • Contract period (e.g., from November 1, 20X3 to March 31, 20×4);
  • An official weather station from which the meteorological record is obtained;
  • Definition of the underlying weather index(W);
  • Strike for put/call or exercise index for swap (both denominated S);
  • Tick (k) for a linear payout scheme or the fixed payment (Po) for a binary payment scheme; and
  • Premium for the put or call.

Historical background

Weather conditions directly affect agricultural outputs and the demand for energy products, and indirectly affect retail businesses. For instance, earnings of the power industry depend on the retail prices and the sales quantities of electricity, which in turn are affected by weather conditions. Until 1997, earnings stabilization for utility firms was primarily achieved through price hedging mechanisms while volumetric risks were largely left unhedged. Weather derivative accounting

However, increasing competition due to ongoing deregulations made it necessary for companies to hedge the volumetric risk caused by unexpected weather conditions. Such needs have created a new class of derivatives, weather derivatives. Since its inception in the late 1990s, the market for weather derivatives has grown steadily. Among all the weather derivative transactions, temperature-related deals are the most prevalent, accounting for more than 80% of all transactions. Weather derivative accounting

Although the impetus of the weather derivatives market comes from the power and energy sectors, weather derivatives can be and have been used by other industries such as the retail business and the tourist industry. Weather derivative accounting Weather derivative accounting

For instance, the inventory level of winter coats at department stores depends on the weather forecast for the coming winter and the eventual sales depend on the actual weather condition. To avoid loss of sales, contracts can be struck to hedge against unfavorable weather conditions. Weather derivative accounting

Temperature derivatives

The underlying variables for weather contracts include temperature, rainfall, snowfall, and humidity, to name a few. However, the most commonly contracted weather variable is temperature.

As the weather market has been born out of demand for risk management products from the power industry, the most common and liquid products are designed to fit its requirements. However, the market has started to actively trade a growing number of indices tailored to the demands of all participants. Weather derivative accounting

Some of the more common indices are: Weather derivative accounting

  • Heating Degree Days (HDD) Weather derivative accounting
    This index is designed to measure how cold a period is compared to a standard temperature (18oC in Europe and 65oF in the US). This index is favoured by the power industry to hedge against a warm winter in which less power needs to be generated as compared to expectations. Weather derivative accounting

  • Cooling Degree Days (CDD) Weather derivative accounting
    Likewise the CDD index is used to measure how warm a period is compared to the standard temperature. This index is favoured by the power industry to hedge against a cool summer in which less power needs to be generated compared to their expectations. This is a common contract in the US where power is required for air conditioning units and not so common in Europe where air conditioning in homes is less common. Weather derivative accounting

  • Other indices Weather derivative accounting
    Statistics for deviations from a given value, averages and quantity are available for: Weather derivative accounting

    • Precipitation; Weather derivative accounting
    • Rainfall; Weather derivative accounting Weather derivative accounting
    • Snowfall; Weather derivative accounting
    • Wind speed and direction; Weather derivative accounting
    • Max or min daily temperature; Weather derivative accounting
    • Sunshine; and Weather derivative accounting
    • Humidity. Weather derivative accounting

The fictitious example in the table below presents the typical elements of a swap and an option. In the New York HDD swap, the tick size is set at USD5,000 per HDD. XYZ Co. agrees to pay ABC Co. a fixed rate of 1,000 HDD and in return for a floating rate, which is the actual accumulated HDD during January, 2002. The realized HDD for January, 2002 is 956. Then the pay off for XYZ Co. at maturity is (956 – 1,000) X USD5,000 = – USD220,000.

The Chicago CDD call option works in a similar fashion. A cap or maximum pay off is typically specified for an option contract. For instance, the pay off function for a call on CDD with a cap is, min[cap, tick X max(0, CDD – strike)].

HDD swap

CDD swap

Location

La Guardia Airport, New York

O’Hare Airport, Chicago

Buyer

XYZ Co. (paying fixed rate)

XYZ Co. (paying call premium)

Seller

ABC Co. (paying floating rate)

ABC Co.

Accumulation period

January 1 – 31, 20X2

June 1 – 30, 20X2

Tick size

USD5,000 per HDD

USD5,000 per CDD

Fixed rate

1,000 HDD

Strike level

190 CDD

Floating rate

the actual HDD for January, 20X2 =

956 HDD

Settlement price

the actual CDD for June, 20X2 =

196 CDD

Pay offs at maturity for the buyer

(956 – 1,000) X 5,000 = – USD220,000

(196 – 190) X 5,000 = USD30,000

Geological Variable

Company A and Company B are both insurance companies. Company B, in exchange for $1 million, agrees to pay Company A a specified amount on the occurrence of a triggering event, which is defined as the occurrence of an earthquake in a specified region of Japan during a specified time frame. Weather derivative accounting

The payment is $100 million multiplied by the magnitude of the earthquake as measured by the Japan Meteorologic al Agency (JMA). If an earthquake occurs, Company A neither has to suffer a loss nor be obligated to pay losses under insurance policies written to receive payment from Company B. Weather derivative accounting

The contract meets the definition of a derivative instrument in that it has an underlying non-financial variable (the occurrence of an earthquake in a particular region of Japan as measured by the JMA index) that is not specific to the holder of the contract, a notional amount ($100 million) and the $1 million payment made by Company A is considered to be a small investment relative to the payment of $100 million if an earthquake should occur, and it has a payment provision resulting in net settlement. Weather derivative accounting

Physical and Financial Variables

An entity purchases a contract that will pay $1,000,000 if aggregate property damage from all hurricanes in the Bahamas exceeds $20,000,000 during the current year. The payment provision under the contract contains two underlyings – a physical variable (i.e., the occurrence of at least one hurricane) and a financial variable (i.e., aggregate property damage exceeding a specified amount $20,000,000). Weather derivative accounting

Because of the presence of the financial variable as an underlying and the $1,000,000 payment is based on the occurrence of a hurricane in the Bahamas (an underlying non-financial variable that is not specific to the holder of the contract), it qualifies as a weather derivative. Weather derivative accounting

See also: The IFRS Foundation

Weather derivative accounting

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