The list of actual contracts in use is extensive and constantly evolving.

WEATHER DERIVATIVES STRUCTURES

The list of actual contracts in use is extensive and constantly evolving. Most of the weather derivatives traded up to date have been swaps, options and structures such as straddles, strangles and collars. In recent months, the weather derivatives market is starting to see customized structures for specific needs such as knockouts, compounds, digitals, one-touch barriers and double-trigger options.

Payoffs are defined as a specified dollar amount (e.g. USD1,000 per degree day) multiplied by differences between the strike heating degree day (cooling degree day) level specified in the contract and the actual HDD (CDD) level that occurred during the contract period.

The strike is usually set relative to the normal climatological values. The market currently seems to be converging on the average over the past 10-15 years (even though there are exceptions, like a significant warming trend that makes average CDDs in previous summers lower than what one would expect.)

In order to limit the maximum payout by any of the counterparties, the contracts are usually capped.

Call and Put Options

Weather derivatives typically have as their underlying asset either HDDs or CDDs.

However, since weather is not in fact a tradable asset, a dollar amount is associated with every degree day in the payoff calculation. For example, consider a CDD call option with a strike of 1,000 CDDs paying USD5,000 per degree day. The payoff for this option is:

where CDD_t|T are the cumulative cooling degree days over the life of the contract. More generally, we can represent the payoffs of the weather puts and calls as:

where p (USD/DD) is the per degree day payoff, X_t|T is the underlying (CDD or HDD), and K is the strike (denominated in terms of the associated underlying measure).

Call and Put Options with a Maximum Payoff (CAP)

In order to avoid excessive payouts on these contracts due to extreme weather, the options often come with a cap or maximum payoff.

where h is the maximum payoff denominated in dollars. Examples are given below.

Weather Swaps

A swap is a combination of a call and put option (no cap) with the same strike and on the same underlying. Degree day swaps can provide revenue stability. The payoff is:

The valuation of a swap with a cap is straight forward:

Another spread position, a collar, insulates the buyer from extreme movements in the underlying asset.

A collar typically consists of purchasing an OTM put (call) with a particular strike, and financing this with the sale of an OTM call (put). The graph on the previous page demonstrates the payoff of the collar.

The general payoff is:

This week’s Learning Curve was written by Mark Garman , president for Financial Engineering Associates , Carlos Blanco , manager of global support and educational services for FEA , and Robert Erickson , senior financial engineer for FEA.

22 Nov 1999

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