Weather Derivativesnecessity, methods and applicationReinhard HagenbrockSeminar of the working group on Climate DynamicsBonn, !" #ai $%%& 'utline()History*(What is a +weather derivative,-(.dealised e/ample(#arket0 players, 1places and re2uirements(3se of meteorology(Summary and outlook )History* of weather derivatives()risk management* of weather risks has always been part of insurance business4storms, crop failure, floods, """4+accident, caused by weather e/tremes is insured(starting point for weather derivatives0 dependency of profit on +weather,(appro/" $% 5 of business activities in western economies 6partly7 dependent on +weather, )History* of weather derivatives(price risk4higher ac2uisition prices 6e"g" for crop74higher energy consumption4e/tra costs 6e"g" for irrigation7(volume risk4in the production 6e"g" agriculture74in the sales 6e"g" ice cream7 )History* of weather derivatives(8rice risks may generally be managed with options 9 long term contracts()weather risk* generally is a volume risk, price risk should by managed independently )History* of weather derivatives(Starting of weather derivatives0 dependency of energy sales on temperature )History* of weather derivatives(:irst weather derivative0 Sep ;;< between two energy suppliers4aim0 to balance electricity sales caused by temperature fluctuations in winter ;;/change since Sep" ;;; What is a +weather derivative,-(""" )derivative financial instrument in which meteorological data 1 e"g" temperature 1 is used as a basis product*(Degree1Day4Heating Degree Day HDD6t7 ? ma/6!@A1B6t7,%74Cooling Degree Day CDD6t7 ? min6B6t71!@A,%74usually summed up over a month9season4sometimes0 DD with other reference temperatures, average temperature What is a +weather derivative,-('ther indices04precipitation(.ndices are dealt like goods What is a +weather derivative,-(lectricity >nterprises finds out0 electricity sales drop by J%% #Wh9day if temperature rises by AC4monthly loss0 6& J%% =7 ? $$&"$%% 4ave" ;!;1;;=0 HDD6:rankfurt7 ? !=!"J4in =9&% years0 HDD6:rankfurt7 K @%%(Contract04Bick siEe0 6J%% =7 ? e/pects that the products are not dealt by end customers but by risk traders secondary market6online17 brokerstock e/changetrader6re17 insurancecompanies6investment17banks #arket(price model4Black9Scholes model, accepted for option prices, is not applicable4no other widely accepted price model premiums not transparent, may vary by a factor %M possible hedgers are discouraged from entering the market4possible +widely accepted price model, must reflect reality, otherwise market prices and economic cost of +weather, differ #arket(market needs to be +complete,4)Hny payoff vector N"""O may be realised"* 4number of traded derivatives matches at least the number of uncertainties 6meteorological parameter, time period, place of measurement, """7 3se of meteorology(Gisted under )problem fields*M(methods re2uire an estimate on the variability of the weather +variable,4generally taken from +historic data, (pricing may depend on length of +historic times series,(&% years seem to be generally accepted4station data from national weather services is strictly preferred 3se of meteorology(8roblems like +heat islands, or relocation of stations are known, data needs to be corrected(stationarity of the stochastic of the weather variable not generally given4higher confidence is given to more recent measurements 3se of meteorology(#eteorological data needs to be of high 2uality, cheap and 2uickly9easily availableAvailabilityCost (ongoing data access)Cost (historic data) QualityGermany 6 7 4 6.-7.France 67 !Great "ritain ! ! 6 !#etherlands! 6 #or$ay ! ! ! 7%$eden ! 7 & 7%'ain 6 () () &*%A !+& () () ! 3se of meteorology(8roblem0 connection between DD value and business performance is often only weak(profit dependent on economic factors4e/ternal0 economic cycles, general social9economic changes, """4internal0 higher efficiency, new markets, """ 3se of meteorology(HDD is a )bad* predictor for the predictandbusiness performance(use of additional meteorological information reduces the amount of une/plained variance*ne,'lained variance- 6( .*ne,'lained variance- 4/ . 3se of meteorology(Disadvantage of using additional meteorological data 6e"g" model output, obPective analysis70 number of control variables increases number of different +markets, increases li2uidity decreases(Qenerally no interest in more comple/ meteorological data than station values"()Clash of Cultures* 3se of meteorology(Specific market traders 6e"g" re1insurance companies7 may have special interest in more comple/ meteorological methods4would reduce risk, increase profit 6especially, if market prices are based on less appropriate methods74#ethods include seasonal prediction and #onte Carlo modelling4MMMB'8 S>CR>BMMM(Reduces possibility for a generally accepted pricing method Summary and 'utlook(Weather derivatives0 #easured weather is traded like goods(large market for business activities with a dependency on weather (#ost common0 HDD and CDD as integrals over period 6month, season7(trade market established in Chicago in ;;nergy market in Qermany is only partly liberalised, competition is low4little need to compete for the consumers4relatively large regions make it possible to manage risk within the enterprise