Commodity hedging through weather derivatives: An option for Indian farmers

Government of India is planning to introduce a bill in the Parliament to amend the Forward Contracts Regulations Act to permit introduction of weather derivatives in Indian commodities market.

Weather derivatives are common abroad which is used for hedging the exposures in energy, crop, plantations etc. which are weather centric. The variations in the precipitations can affect crop/plantation yields thereby affecting the income of the farmers/growers.

Though the losses on account of natural calamities are hedged through insurance, the market risk on account of climatic changes does not come under the purview of insurance.

Weather derivatives are also contracts similar to equity or commodity derivatives. However, the pay offs in the case of weather derivatives are based on weather related measurements such as temperature, rainfall, snow fall, wind speed etc. Around 85 per cent of the weather derivatives contracts are based on temperature.

These contracts are structured based on number of Heating Degree Days (HDD) or Cooling Degree Days (CDD). The first over the counter weather derivatives were introduced in 1997 (Hull, 2003). The Weather Risk Management Association was formed to serve the interest of the weather risk management industry.

Heating Degree Days (HDD) is calculated by deducting the average temperature of each day in the reference period from a reference temperature. Average temperature is calculated by taking the average of midnight-to-midnight high and low temperature of a day. The reference period can be one year or one month depending up on the risk exposure of the firm. Internationally the reference temperature is taken as 18 degree C or 65 degree F. Where the days temperature is less than the reference temperature it is taken as HDD. The HDD cannot be negative. HDD indicates how many days heating is necessary.

Cooling Degree Days are calculated by deducting the reference temperature from the days temperature. Exchange-traded weather derivatives based on temperature are now also offered on the London International Financial Futures Exchange and the Helsinki Exchange. There are no exchange-traded derivatives available for wind- or precipitation-based derivatives. Of late wind derivatives are also traded in exchanges.

Privately negotiated weather derivatives contracts are typically based on the standard International Swaps and Derivatives Association (ISDA) Master Agreement, which is the same form of agreement used for derivative agreements involving physical commodities.

In October 2003, in response to the growing volume of weather derivatives transactions, ISDA published a series of new template confirmations and appendices, including form confirmations for weather index swaps, put options and call options, as well as form appendices for CDD, HDD and CPD index transactions.

In India NCDEX had made an attempt to introduce weather index as back as in 2004. The current initiative by the government will definitely help the exchanges to introduce this hybrid commodity hedging tool in Indian market.

The advantage of weather derivative is that a farmer who expects high crop due to strong monsoon also faces the risk of low yield if the monsoon becomes weak, can protect himself from a potential loss.

A weather index which is structured based on temperature will protect him from the loss of income from fall in yield by buying weather futures because when the temperature goes up the monsoon becomes weak. Hence he can sell the futures at a high price and make up the loss in the yield.

These hedging tools are highly useful to Rubber planters and growers of spices like cardamom, ginger, turmeric etc. Weather futures will also help electricity boards to hedge their price risk on account of lower electricity production due to low rain fall in the catchments areas of dam sites.

Rain derivatives and precipitation derivatives also can be carved out using the rain fall and precipitation data. These hybrid hedging tools will definitely help the Indian farmers to earn a sustainable income level driving away the fear of loss from natural calamities.