Government is planning to introduce a bill in the Parliament for permitting trading in hybrid derivative products like weather and rain derivatives. These products are intended to help the producers of commodities which are dependent on rain and changes in weather conditions so that they would be able to hedge their price risks. In this brief article I am trying to examine the use of weather derivatives for hedging the price risk of commodity producers of agricultural commodities like paddy, wheat, sugar etc. and plantation crops like rubber, pepper, cardamom etc.
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. 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).
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° C or 65°F. Where the day’s 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 day’s 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 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.
Weather related derivatives can be futures, options or swaps. Futures are contracts for delivery on a future date where the price will be fixed now. The futures are priced by applying the cost of carry model. Under this model it is assumed that the hedger takes a position by borrowing and on maturity he sells the futures and pay off his/her borrowings with interest. As the contacts approaches the expiry, the future price and spot price converges due to the low demand for the futures. The futures are generally exchange traded where margin as per the norms of the exchange. The margin requirements enable the exchange to ensure liquidity and avoid the counter party risk.
Another type of weather derivative is options. Options are contracts for delivery of the underlying assets on a future date. The underlying asset can be shares, bonds, commodities, weather etc. The buyer of an option enjoys the right of protection where as no obligation for delivery. Therefore, he/she can abandon the options if the price moves against him. The options can be American type or European type. While American options permit the buyer to take/give delivery on any day during the life of the option, European option can be exercised only on the expiry date. Since the option buyer enjoys the right to abandon, he/she has to pay an upfront fee as premium. The price mutually agreed upon for the delivery of the asset is known as the strike price. The option pay off is calculated by finding out the difference between the strike price or exercise price and spot price. If the spot price is more than the strike in the case of a call option, the option is considered as in-the-money. Whereas if the strike is more than the spot price in the case of call option, the option is considered to be out-of-the-money. The difference between the spot and strike prices is known as intrinsic value. The option can be deep in the money or deep out of the money depending on the size of option pay off.
A number of models are available for pricing the options among which the most commonly used formula is by Black and Scholes. Option price can also be calculated using a binomial tree. The option prices are influenced by certain factors such as spot price of the underlying asset, strike/exercise price, volatility of the asset price, risk free interest rate and the period to maturity. A hedger is able to protect his asset by taking an opposite position in the derivative market. For example, if a hedger is long in asset, he should be short in derivatives.
Weather/rain futures and options are helpful to farmers and producers of commodities to hedge their price risk because the weather conditions can increase or decrease the crop production. For example take the case of paddy or rubber. Good monsoon can increase the paddy crop. At the same time heavy rain can reduce the latex production and in turn reduce the rubber production. Given the increasing demand for rubber by tyre manufacturers, the rubber prices can go up if production comes down and prices can go down if production goes up, provided the synthetic rubber which is the substitute for natural rubber becomes costly or cheaper due to changes crude oil prices. A producer, who expects that the monsoon will be strong and his production will increase, may also face the danger of flood if the monsoon becomes extremely heavy which can damage the paddy crops. Take for example a rubber producer who expects that the monsoon will be strong and he considers that the latex production will be affected leading to increase in prices. He can buy rain futures and lock in his prices so that if the monsoon becomes weak and production is not affected, he can protect himself from a fall in price. On the other hand if the monsoon becomes strong and the prices go up he can sell the physical rubber and loss in the futures contract can be offset with the gain in physical sales. Another method is buying or selling options. But option contracts are not practiced in commodity trade in India.
Though weather derivatives are practiced in advanced countries abroad, this hybrid hedging tool is still strange in Indian market. NCDEX had come out with a proposal to introduce weather index in India and their proposal was lying with the regulators for approval. However, Government of India is now mulling to amend the Forward Contracts Regulations Act to facilitate introduction of weather derivatives in Indian commodity exchanges. The move is expected to provide Indian farmers to bet against weather changes and protect themselves from the potential losses on account of climatic factors. Though the motives behind this initiative is appreciable, in the back drop of strong protests raised by the end users of commodities against futures trading in commodity market for fear of artificial price rise, one needs to wait and see how far this move could be materialized.
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. 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).
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° C or 65°F. Where the day’s 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 day’s 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 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.
Weather related derivatives can be futures, options or swaps. Futures are contracts for delivery on a future date where the price will be fixed now. The futures are priced by applying the cost of carry model. Under this model it is assumed that the hedger takes a position by borrowing and on maturity he sells the futures and pay off his/her borrowings with interest. As the contacts approaches the expiry, the future price and spot price converges due to the low demand for the futures. The futures are generally exchange traded where margin as per the norms of the exchange. The margin requirements enable the exchange to ensure liquidity and avoid the counter party risk.
Another type of weather derivative is options. Options are contracts for delivery of the underlying assets on a future date. The underlying asset can be shares, bonds, commodities, weather etc. The buyer of an option enjoys the right of protection where as no obligation for delivery. Therefore, he/she can abandon the options if the price moves against him. The options can be American type or European type. While American options permit the buyer to take/give delivery on any day during the life of the option, European option can be exercised only on the expiry date. Since the option buyer enjoys the right to abandon, he/she has to pay an upfront fee as premium. The price mutually agreed upon for the delivery of the asset is known as the strike price. The option pay off is calculated by finding out the difference between the strike price or exercise price and spot price. If the spot price is more than the strike in the case of a call option, the option is considered as in-the-money. Whereas if the strike is more than the spot price in the case of call option, the option is considered to be out-of-the-money. The difference between the spot and strike prices is known as intrinsic value. The option can be deep in the money or deep out of the money depending on the size of option pay off.
A number of models are available for pricing the options among which the most commonly used formula is by Black and Scholes. Option price can also be calculated using a binomial tree. The option prices are influenced by certain factors such as spot price of the underlying asset, strike/exercise price, volatility of the asset price, risk free interest rate and the period to maturity. A hedger is able to protect his asset by taking an opposite position in the derivative market. For example, if a hedger is long in asset, he should be short in derivatives.
Weather/rain futures and options are helpful to farmers and producers of commodities to hedge their price risk because the weather conditions can increase or decrease the crop production. For example take the case of paddy or rubber. Good monsoon can increase the paddy crop. At the same time heavy rain can reduce the latex production and in turn reduce the rubber production. Given the increasing demand for rubber by tyre manufacturers, the rubber prices can go up if production comes down and prices can go down if production goes up, provided the synthetic rubber which is the substitute for natural rubber becomes costly or cheaper due to changes crude oil prices. A producer, who expects that the monsoon will be strong and his production will increase, may also face the danger of flood if the monsoon becomes extremely heavy which can damage the paddy crops. Take for example a rubber producer who expects that the monsoon will be strong and he considers that the latex production will be affected leading to increase in prices. He can buy rain futures and lock in his prices so that if the monsoon becomes weak and production is not affected, he can protect himself from a fall in price. On the other hand if the monsoon becomes strong and the prices go up he can sell the physical rubber and loss in the futures contract can be offset with the gain in physical sales. Another method is buying or selling options. But option contracts are not practiced in commodity trade in India.
Though weather derivatives are practiced in advanced countries abroad, this hybrid hedging tool is still strange in Indian market. NCDEX had come out with a proposal to introduce weather index in India and their proposal was lying with the regulators for approval. However, Government of India is now mulling to amend the Forward Contracts Regulations Act to facilitate introduction of weather derivatives in Indian commodity exchanges. The move is expected to provide Indian farmers to bet against weather changes and protect themselves from the potential losses on account of climatic factors. Though the motives behind this initiative is appreciable, in the back drop of strong protests raised by the end users of commodities against futures trading in commodity market for fear of artificial price rise, one needs to wait and see how far this move could be materialized.
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