SciFinance®

Back With The Weather

After a somewhat lengthy absence (due to computer crash and a very tight schedule), I am glad to be back. My apologies to the Wilmott team for my temporary departure.

Let me get re-started by posting a weather derivatives piece that was published by the FT a few weeks ago and where I get quoted a few times. Interesting stuff for those considering weather products as hedging or punting instruments.

Sun shines again on weather derivatives

Many assumed that weather derivatives had disappeared with Enron, and that these financial instruments were but a byproduct of those over-exuberant days.

But weather is rapidly becoming the centre of the one of the most attractive sectors in the financial markets. Increasing volatility in the weather is helping to fuel the trading of related derivatives, or futures contracts that allow investors to bet on or hedge against fluctuations in the weather.

Among the most powerful catalysts has been the entry of hedge funds into weather derivatives market over the past five years. "The market was struggling along at $4bn or so until the hedge funds arrived - now it's some 10 times that," says Pablo Triana, a professor at Madrid's Instituto de Empresa and an expert in weather derivatives.

Peter Brewer, fund manager for the Cumulus Weather Fund, says weather derivatives are an attractive investment proposition. "I think it's a perfect market. You can't spook it, you can't manipulate it. You can't make people think it's going to be 110 degrees in London next week," he says. "And of course, weather is absolutely uncorrelated [to other asset classes]."

Ilija Murisic, executive director of Hybrid Derivatives Trading at UBS says interest in the bank's new Global Warming Index - launched last month - was driven by investors' desire to diversify their portfolios. Global warming and climate change have also attracted investors to the market, says Juerg Trueb, managing director at Swiss Re. "In those regions where you see significant weather events going on, you definitely see demand popping up," Mr Trueb says, citing a recent drought in Australia and Hurricane Katrina in the US.

That development has left enthusiasts such as Mr Triana arguing that the market has the potential to be the biggest in the world. "Anything is possible, because there's no weather risk you can't hedge," he says.

However, not everybody agrees - not least because past attempts at expanding the weather derivatives market have run into serious obstacles and products have failed to gain traction among mainstream investors.

Enron, the fallen US energy company, launched the first widely known weather derivatives deal with Koch Energy Trading in 1997, structured around temperature fluctuations that winter. Under the terms of the deal, Enron would pay Koch $10,000 for every degree the temperature fell below a predetermined level, while Koch would pay the same for every degree above it. Enron expected companies of all shapes and sizes to embrace the new product. Potential customers ranged from retailers to ski resorts.

But even today, a decade later, companies are slow to embrace these products. This is despite the fact that most companies in the world have exposure to changes in weather. Mr Triana blames this slow uptake partly on the relative complexity of the market. "Participants have to be able to calculate what their exposure is to the weather," he says. "A company can easily gauge its interest rate exposure, or assess the effects of exchange rate fluctuations. Measuring the impact of weather on revenues is trickier, and much tougher for corporate treasurers." Dealers selling the product also have few incentives to target corporate clients aggressively. "A lot of the possible transactions would be smallish in size - a London pub worried about £15,000 in losses because it rained and customers couldn't sit outside, drinking in the sunshine," Professor Triana said.

Several leading investment banks - including Société Générale and BNP Paribas - shuttered their weather derivatives operations earlier this decadefor just those reasons. Yet other market participants are increasingly optimistic. WeatherBill, a SanFrancisco-based start-up run by former Google employees, is a prime example. "Our mission is to remove the risk of weather from all businesses, for all needs and all purposes," chief executive David Friedberg said, adding that "no contract is too small. We've sold a weather derivative contract for a dollar". Mr Friedberg's clients include car wash companies, hair salons and golf courses. "I'm also on the phone to farmers all the time," he said. "The other day one farmer rang me up and said his sows wouldn't make a move to mate if the temperature went above 95 degrees Fahrenheit. He wanted to hedge against that."

Still, it's unclear whether a reliance on small contracts will sustain such a business. In fact, Weatherbill only offers contracts to businesses with assets of at least $1m or individuals worth $5m or more. But the company is pursuing larger clients. Last Week, Weatherbill announced a C$100m ($94m) contract with Canada's largest online travel retailer, which will be paid out based on snowfall.

A Convenient Truth

Whether you agree with Al Gore´s most alarmist comments or not, it seems beyond doubt that the planet has been witnessing strange weather patterns of late. Climate change and global warming have become inevitable buzzwords of our times, the most serious problems facing humanity according to many, a must-have theme for power-seeking politicians.

The general consensus seems to be that the globe is getting hotter, with suffocating summers and mild winters. The possibility of water-shortages and even outright droughts is thus enhanced, as is the prospect of stagnant snowfall volumes. Hurricanes and similarly-dramatic events are likely to become more familiar. Whatever the final specific consequences, what´s clear to all of us non-Martians is that the weather has turned trickier, more disturbing, and more unpredictable. Somber times may lie ahead. If Gore´s mayhem-announcing, Oscar-winning documentary and the tons of supporting scientific evidence are in fact on target, we better run for cover.

If the reality of changing climate seems beyond dispute, what is a bit more debatable is whether human actions are behind such modifications. Most experts (real and self-appointed ones) point their fingers at us. But, to be fair, at the same time some minority contrarian voices have protested such overwhelming verdict, relieving humans of ultimate responsibility. Even if we ultimately assume that people are irrefutably guilty for ski-less winters and dry golf courses, an interesting paradox presents itself: while devious humans would have put the planet (and themselves) in jeopardy, they have at the same time brilliantly developed tools that afford economic protection from those very same developments. Just as the earth´s weather may be experiencing artificially-created changes for the first time since Genesis, humankind has for the first time in history the capacity to effectively shelter itself from climate-induced malaise (even the self-inflicted type).

Weather derivatives are those magical tools that can save us from ourselves (or, if you are a Gore-doubting contrarian, from mischievous nature). By providing financial compensation in the event that a certain weather variable deviates from a pre-set level, these products allow companies, governments, and individuals to sleep easier at night. Weather derivatives are available on temperature, rainfall, snowfall, wind speed, hurricanes, humidity, typhoons, sea wave hights, and frost days, among other variables. In essence, then, it is now possible to receive monetary cover if it’s hotter or colder than a certain level, if it rains above or below a certain level, or if it snows more or less than a certain level.

Even without climate change, the usefulness of weather derivatives would be clearly obvious. Few businesses and nations around the world can claim to be insensitive to the fluctuations of the weather. The weather has undeniably critically important economic consequences. Some estimates indicate that four-fifths of all economic activity worldwide is directly or indirectly affected by the weather. The truth is that people have been worrying about the economic effects of weather for centuries, but could not do anything about it (though some civilizations did try offering human sacrifices as a way to placate the gods). Since the late 1990s, weather derivatives can do the job.

From its birthplace in the Houston-based trading floor of, yes, Enron, weather derivatives (now exactly one decade old) have experienced consistent growth and innovation, with the last lustrum having witnessed truly outstanding strength. This is a market that is now highly liquid, accesible, and popular. Without a doubt, weather derivatives are one of the most sensational success stories to have afflicted the economic landscape in recent years. They are a testament to the power to devise solutions to incredibly important, incredibly complex problems. In what may be the most impacting example of such capableness, last year a product was engineered to hedge Ethiopia from the risk of drought-induced famine, in effect a tool designed to save thousands of lives.

Perhaps the most important lesson to come out of the climate change story is what an extremely curious species we humans are. We may have the capacity to alter the divine earthly weather patterns that we inherited and to perhaps even threaten our very existence as a result, but we also have the abilility to engineer awe-striking genius solutions to the problem. While our reckless actions put at risk our livelihoods, our inventiveness and intellectual prowess allow us the comfort of feeling sheltered from ourselves. Humans brainpower and capacity for innovation can thus effectively shield the species from disaster. The realization of such miraculous capabilities is in itself a very potent reason to preserve the habitat that lets us be.

ptriana@profesor.ie.edu

Cooler Than Madonna

On the night of January 28th 1985, more than forty blockbuster musicians gathered in Hollywood to record a single song. “We are the World”, co-written by Michael Jackson and Lionel Ritchie, was the American version of a prior British effort (dubbed “Band Aid”) to raise emergency funds that may help alleviate the pain of drought-induced famine in Ethiopia. By the time that the record hit the stores (on March 7th, selling all 800,000 initial copies over a single weekend), more than one million poor Ethiopians had died of starvation and malnutrition. In all, “We are the World, “Band Aid”, and “Live Aid” (the mega concert simultaneously held in London and Philadelphia the following July) together raised some $100 million, a truly impressive sum. The valiant contributions of Madonna, Bruce Springsteen, Bob Dylan, and many other mega stars, however, had simply arrived too late. Just like all traditional aid programs, the efforts by the author of “Like A Virgin” and her peers represented “ex-post” approaches to humanitarian relief. That is, the money only started to flow way after disaster had struck. As early as March 1984, the Ethiopian government began to appeal for international help as a response to the unusual lack of rain in the early Spring season. By August, people were dying by the thousands. It was only in October, when TV images of moribund Ethiopian children with sunken eyes and bloated bellies shamed the world, that serious relief efforts began to take shape. By the end of the year, Western countries had donated tens of millions of dollars, but the damage had been done: 900,000 Ethiopian farmers were dead, and the rest were mostly destitute as a result of having had to dispose of all their assets in order to survive.

Today, thanks to the work of financial wizzards, the world has access to tools that can provide relief funds to poor countries such as Ethiopia before disaster strikes, thus potentially preventing situations like those of 1984 and 2000, when another large-scale drought took place, claiming once more thousands of lives. Weather derivatives, in sharp contrast to aid agencies or artistic initiatives, offer “ex-ante” solutions to humanitarian crisis. That is, the funds would be readily available before destitution and famine are allowed to take hold. Before embarrasing media reports depict a tragic reality. Before Britney Spears has to come up with an aiding song. Weather derivatives, in sum, have the power to save the world’s downtrodden from a tortuous death. What Madonna could not deliver, weather derivatives miraculously can.

Last March 2006, the United Nations World Food Programme (WFP) arranged the first ever “humanitarian insurance” weather deal. The contract, underwritten by French reinsurer Axa Re, was intended to provide $7 million in immediate contingency funding in case of an extreme drought during Ethiopia’s 2006 agricultural season (which spans the March-October period). Though obviously the key variable was rainfall data, and the derivative could reasonably be seen as precipitation-related, in practice the underlying was a so-called “livelihood losses index” that measured the economic losses (in $ terms) resulting from droughts for rural populations living in the agriculturally-productive regions of Ethiopia. To be precise, if the index value was above $55 million on 31st October 2006, WFP would instantly receive a payout from AXA Re of $0.35 for every $1 the index is above the trigger level, up to a maximum of $7.1 million. Conversely, if the index value was below $55 million, no payment would be made. In the end, it did rain quite a lot in Ethiopia last year, so the derivative did not expire in-the-money. However, the pilot has got to be deemed a resounding success, as being able to place Ethiopian famine risk in the international capital markets was certainly a superb challenge to begin with.

Ex-post approaches to humanitarian crisis risk significant loss of livelihoods and may not be able to cope. While well-meaning aid programs like those featuring celebrity artists in the mid 1980s are surely helpful, they can only alleviate some of the pain once disaster has struck, but cannot prevent the malaise from happening in the first place. Weather derivatives, in sharp contrast, can potentially perform the miraculous task of providing economic assistance precisely at the right time, before famine and destitution have taken hold. The hope is that initiatives such as the WFP’s Ethiopian program, with their ex-ante approach to economic relief, will make aid more efficient and timely. That is, with weather derivatives you do not need to wait until you see people dying on TV; you can actually prevent those images from ever becoming reality. The message couldn’t be more crystal-clear: before weather derivatives there was no sure-fire way to prevent famine in Ethiopia and other poor areas of the globe; after weather derivatives, the task is possible. While twenty years ago the beautiful “We are the World” theme made the planet tremble with emotion and determined to aid those destitute Ethiopians, today’s weather derivatives can sing a more effective tune and miraculously eliminate the problem once and for all.