158 THE MODELING OF WEATHER DERIVATIVE PORTFOLIO RISK£5,500,000. Thisroughlybalancesthemoneytheyloseontheirgassupplybusiness.
In the second year they test a different strategy: they sell a swap with a strike of 1670
HDDs, a tick of £50,000/HDD, and limits at both ends of £10,000,000. Again the
weather comes in warmer than normal, this time at 1640 HDDs. Again, they lose
money on their gas business but make money on the weather derivative: this time
£1,500,000.This example illustrates the following important points. First, weather
derivatives are based on weather measured at a specific location: in this
case, London (in a real example it would probably be London’s Heathrow
Airport, weather station 03772). Second, weather derivatives are based on
a weather index that has a single value per year: in this case, this index is
the total number of HDDs during the winter season for this location. Third,
there is a function that relates the value of the weather index to a payoff.
Puts, calls and swaps are the most common functions used, but any other
function is also possible. Swaps are typically traded without a premium,
while options have a premium. Fourth, weather derivatives may have a
limit on the financial payout. Typically, over the counter (OTC) contracts
have limits while exchange traded contracts do not.
The example given above is very typical of trades in the weather market.
Variations include:(a) Usingdifferentlocations: London, NewYork, ChicagoandTokyoarethe
most commonly traded locations, but many hundreds of other locations
have also been used, and any location with reliable weather measure-
ments is a potential candidate. For a hedger there may be a trade-off
between using a location at which the weather correlates highly with
their business, and using a commonly traded location for which better
prices would be available.(b) Using different weather variables: the bulk of the current market is
based on temperature, but precipitation contracts are common, and
wind contracts have also traded.
(c) Using different indices: temperature contracts are usually based on
HDDs, as above, but can also be based on average temperature, the
sum of daily temperatures, the number of days where the temperature
exceeds a certain threshold, and so on.(d) Using different time periods: monthly and seasonal contracts are the
most common, although there are also contracts traded OTC with time
periods as short as one hour.
(e) Using multiple locations or multiple variables at once in a single
contract.
(f) Combining the definition of the index with financial variables such as
gas price or power price.