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Weather Derivative Pricing and Risk Management Applications Jon Tindall

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Page 1: Weather Derivative Pricing and Risk Management Applications · Much less common than temperature-based derivatives. Market was born out of temperature exposure. ‘Discreetness’

Weather Derivative Pricing and Risk Management Applications

Jon Tindall

Page 2: Weather Derivative Pricing and Risk Management Applications · Much less common than temperature-based derivatives. Market was born out of temperature exposure. ‘Discreetness’

1. Introduction2. Pricing Principles3. Temperature Derivatives4. Rainfall Derivatives

Overview

Page 3: Weather Derivative Pricing and Risk Management Applications · Much less common than temperature-based derivatives. Market was born out of temperature exposure. ‘Discreetness’

1. Introduction

Page 4: Weather Derivative Pricing and Risk Management Applications · Much less common than temperature-based derivatives. Market was born out of temperature exposure. ‘Discreetness’

First formal recorded transaction in 1996 – Enron and Energy-Koch .

• HDD swap – Milwaukee, winter 1997

• De-regulation of energy industries – mainly in US and Europe.

• Initially used as a hedge against variability in electricity supply.

US Department of Commerce estimates that weather adversely affects:

• 70% of all US companies;

• 22% of total GDP.

Introduction

Page 5: Weather Derivative Pricing and Risk Management Applications · Much less common than temperature-based derivatives. Market was born out of temperature exposure. ‘Discreetness’

� Mature Over-the-Counter (OTC) market:

• Existed since early 1990’s.

• Specifically ‘tailored’ products.

• Large European banks and insurance brokers.

� Chicago Mercantile Exchange (CME):

• operates electronic exchange for weather derivatives.

• futures and option contracts over US and Canadian cities.

• 55% of total global turnover in 2005.

� L.I.F.F.E – Closed in 2004

• series of contracts based on daily average temperatures in London, Paris and Berlin.

Weather Markets

Page 6: Weather Derivative Pricing and Risk Management Applications · Much less common than temperature-based derivatives. Market was born out of temperature exposure. ‘Discreetness’

Market Size

* Source: PwC 2005 Market Survey

$0

$1,000

$2,000

$3,000

$4,000

$5,000

$6,000

$7,000

$8,000

$9,000

2001 2002 2003 2004 2005 OTC Summer OTC Winter CME Summer CME Winter

Market size 2001 - 2005

�Stagnant after Enron collapse.

�2005 shows strong growth may be returning.

Page 7: Weather Derivative Pricing and Risk Management Applications · Much less common than temperature-based derivatives. Market was born out of temperature exposure. ‘Discreetness’

Contract Types:• Futures - CME, OTC.

• Options – Majority of transactions to date.

• Swaps - increasing in popularity.

Underlying Variables:• Temperature

• Rainfall

• Wind Speed

• Snow Fall

• Barometric Pressure

Contracts

Page 8: Weather Derivative Pricing and Risk Management Applications · Much less common than temperature-based derivatives. Market was born out of temperature exposure. ‘Discreetness’

Contract Types

* Source: PwC 2005 Market Survey

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

2001 2002 2003 2004 2005

Other Temp. HDD CDD Rain Snow Wind Other

Break-up of Transaction Types

�Large increases in rainfall contracts.

�CDD now equal with HDD contracts.

Page 9: Weather Derivative Pricing and Risk Management Applications · Much less common than temperature-based derivatives. Market was born out of temperature exposure. ‘Discreetness’

� Average daily temperature

� The most popular derivative contracts are over Heating Degree Days (HDD) and Cooling Degree Days (CDD).

• Where the reference level, T, is usually 18º.

• Heating is generally required below the reference temperature and cooling above it.

• Cumulative number of degrees the average temperature was below the reference level

Temperature Derivatives

)}(,0max{ i

month

TTHDD −= ∑

)}(,0max{∑ −=month

i TTCDD

2

minmax TTT i

+=

Page 10: Weather Derivative Pricing and Risk Management Applications · Much less common than temperature-based derivatives. Market was born out of temperature exposure. ‘Discreetness’

Much less common than temperature-based derivatives.

� Market was born out of temperature exposure.

� ‘Discreetness’ of Rainfall

• Basis risk - greatest barrier to expansion.

• Modelling difficulties.

� Lack of counter-parties – only water supply companies as a possible partner.

Rainfall Derivatives

Page 11: Weather Derivative Pricing and Risk Management Applications · Much less common than temperature-based derivatives. Market was born out of temperature exposure. ‘Discreetness’

Energy / Utility Companies

� Sales are highly correlated with temperatures.

� Definition of HDD and CDD contracts is based on an energy companies exposure.

• Heating/cooling reference level (18º)

• Cumulative based underlying variable.

� Enron

• Oil and gas pipeline manager.

• Used weather derivatives to reduce exposure to weather.

• Soon became a ‘market-maker’ on CME and others.

Risk Management Applications

Page 12: Weather Derivative Pricing and Risk Management Applications · Much less common than temperature-based derivatives. Market was born out of temperature exposure. ‘Discreetness’

Hedging Temperature

Page 13: Weather Derivative Pricing and Risk Management Applications · Much less common than temperature-based derivatives. Market was born out of temperature exposure. ‘Discreetness’

Construction

� Temperature:

• Concrete curing (setting) is temperature dependent.

• Productivity reduces at unusually high and low temperatures.

• ‘Stop work’ laws.

� Rainfall:

• Precipitation delays can often represent 10% of contract.

• Subsidence.

� Other exposures:

• Snow fall.

• Wind speed – cranes and other heavy equipment.

Risk Management Applications

Page 14: Weather Derivative Pricing and Risk Management Applications · Much less common than temperature-based derivatives. Market was born out of temperature exposure. ‘Discreetness’

Some key differences:

� Identifiable Loss: There is no need to prove that a loss has occurred. Reduces costs – claims assessors, lawyers etc.

� Moral Risk: Nearly entirely removed – referenced to a transparent index

� Minimal Underwriting: Only counter-party risk requires investigation.

� Immediate Payout – known magnitude.

� Basis risk

Weather Derivatives vs. Insurance

Page 15: Weather Derivative Pricing and Risk Management Applications · Much less common than temperature-based derivatives. Market was born out of temperature exposure. ‘Discreetness’

2. Pricing Principles

Page 16: Weather Derivative Pricing and Risk Management Applications · Much less common than temperature-based derivatives. Market was born out of temperature exposure. ‘Discreetness’

Traditional Black-Scholes assumptions:

• A traded underlying asset that can be used to create a hedge, i.e. sold short.

• Log-normal distribution.

Other methods must be found for the pricing of these contracts:

• Alternative BS framework.

• Martingale approach.

• Numerical simulation.

Pricing

Page 17: Weather Derivative Pricing and Risk Management Applications · Much less common than temperature-based derivatives. Market was born out of temperature exposure. ‘Discreetness’

• Weather variables do not rise or fall without bound

• Mean reversion strength depends on several factors – most significantly latitude.

Mean-reversion component:

Ornstein-Uhlenbeck (OU) process:

Modified OU process:

Mean Reversion

).( XXdt

dXt

t −−= γ

ttt dWdtXXdX .).( σγ +−=

t

t

t dWdtdt

XdXXdX .)( σγ +

+−=

Page 18: Weather Derivative Pricing and Risk Management Applications · Much less common than temperature-based derivatives. Market was born out of temperature exposure. ‘Discreetness’

� Futures Price:

� Process s.d.e:

� Modified Black-Scholes p.d.e:

� Solution:

Alternative Black-Scholes

)(. tTr

tt eXY−=

2

222

2

1

dy

VdyrV

dt

dV t σ−=

),0,,(.

),,,(),(

σ

στ

τ

tyBSe

rtyeBStyV

r

r

=

=

])[( tt dWdtrydY σµ +−=

Page 19: Weather Derivative Pricing and Risk Management Applications · Much less common than temperature-based derivatives. Market was born out of temperature exposure. ‘Discreetness’

‘Burn’ Analysis:

• No assumptions needed re: the process dynamics;

• No parameters to be estimated;

• Agreement on price.

Monte Carlo Simulations:

• Model dependant;

• Data intensive.

Numerical Methods

)),((.1

)]([1

i

N

i

t tXfN

Xf ψ∑=

=E

Page 20: Weather Derivative Pricing and Risk Management Applications · Much less common than temperature-based derivatives. Market was born out of temperature exposure. ‘Discreetness’

3. Temperature Modellingand Derivative Pricing

Page 21: Weather Derivative Pricing and Risk Management Applications · Much less common than temperature-based derivatives. Market was born out of temperature exposure. ‘Discreetness’

Australian Bureau of Meteorology (BOM)

� Sydney Airport. (Jan 1940 – Dec 2005)

� Observatory Hill. (Jan 1940 – Dec 2005)

� Prospect Dam. (Jan 1965 – Dec 2005)

Missing data:

�Temperature – Backup stations.

�Rainfall – much more difficult. No accurate measure due to discreetness of rainfall.

Data

Page 22: Weather Derivative Pricing and Risk Management Applications · Much less common than temperature-based derivatives. Market was born out of temperature exposure. ‘Discreetness’

� Bi-modal Distribution

Temperature Distributions

AveT emp - SydAirport

0

200

400

600

800

1000

1200

1400

1600

1800

2000

6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36

Ave. T emp (degrees C)

Co

un

t

AveTemp

Average D aily T em p. - S yd ney Airp ort

0

2 0 0

4 0 0

6 0 0

8 0 0

1 0 0 0

1 2 0 0

1 4 0 0

1 6 0 0

1 8 0 0

6 7 8 9 1 0 11 1 2 13 14 1 5 16 1 7 1 8 1 9 2 0 2 1 2 2 2 3 2 4 2 5 2 6 2 7 2 8 29 3 0 31 32 3 3 34 3 5

Av e. T em pe rature (d eg C )

Co

un

t

W inte r M onths (M ay-O ct)

S um m er M o nths (Nov-A p r)

Page 23: Weather Derivative Pricing and Risk Management Applications · Much less common than temperature-based derivatives. Market was born out of temperature exposure. ‘Discreetness’

Steps:

• De-trend data;

• Choose functional form for seasonal fluctuations;

• Estimate the parameters, including mean-reversion;

• Simulate the process;

• Analyse residuals.

Modelling Temperature

Page 24: Weather Derivative Pricing and Risk Management Applications · Much less common than temperature-based derivatives. Market was born out of temperature exposure. ‘Discreetness’

All temperature data sets revealed a significant positive slope

• Time series over 70 years should de-trend with a quadratic function.

• Natural geological based heating + human induced global warming

Long-term Trends

2.. tctbaTlong ++=

tbaT Long .+=

Page 25: Weather Derivative Pricing and Risk Management Applications · Much less common than temperature-based derivatives. Market was born out of temperature exposure. ‘Discreetness’

Fourier series to model seasonal component:

�A first order series is sufficient to capture seasonal pattern.

Combining this with the linear trend we obtain:

Seasonal Trends

∑∑ ++++=i

i

i

iSeasonal tCostSinT )()(.0 θλβφγαεα

)()(.. θλβφγα +++++= tCostSintbaT

Page 26: Weather Derivative Pricing and Risk Management Applications · Much less common than temperature-based derivatives. Market was born out of temperature exposure. ‘Discreetness’

Model Fit

-15.00

-10.00

-5.00

0.00

5.00

10.00

15.00

0 500 1000 1500 2000 2500 3000 3500

Days

Te

mp

. (d

eg

C)

Actual Ave. Temp

Modelled Temp.

Actual vs Expected – Sydney Airport (10 years)

Page 27: Weather Derivative Pricing and Risk Management Applications · Much less common than temperature-based derivatives. Market was born out of temperature exposure. ‘Discreetness’

Temperature Volatility

Daily Temperature Volatility – Sydney Airport (10 years)

0

2

4

6

8

10

12

1

10

19

28

37

46

55

64

73

82

91

10

0

10

9

11

8

12

7

13

6

14

5

15

4

16

3

17

2

18

1

19

0

19

9

20

8

21

7

22

6

23

5

24

4

25

3

26

2

27

1

28

0

28

9

29

8

30

7

31

6

32

5

33

4

34

3

35

2

36

1

Day of Year

%

Raw Mod

� Degree-4 polynomial fitted to volatility distribution.

Page 28: Weather Derivative Pricing and Risk Management Applications · Much less common than temperature-based derivatives. Market was born out of temperature exposure. ‘Discreetness’

• Parameter estimation – least squares

• Residuals – Sydney Airport.

Parameter estimation

Syd. Airport Observatory Prospect

a 16.925 17.434 17.26 b 6.30*10

-5 5.16*10

-5 4.91*10

-5

α 5.14 4.91 5.194 β 0.69 -0.20 0.986 φ 1.097 1.25 1.100 θ 0.97 1.10 0.675

Residual Distribution

0

500

1000

1500

2000

2500

3000

3500

-5.0

0

-4.6

0

-4.2

0

-3.8

0

-3.4

0

-3.0

0

-2.6

0

-2.2

0

-1.8

0

-1.4

0

-1.0

0

-0.6

0

-0.2

0

0.2

0

0.6

0

1.0

0

1.4

0

1.8

0

2.2

0

2.6

0

3.0

0

3.4

0

3.8

0

4.2

0

4.6

0

5.0

0

Residual

Co

un

t

Page 29: Weather Derivative Pricing and Risk Management Applications · Much less common than temperature-based derivatives. Market was born out of temperature exposure. ‘Discreetness’

• CDD option - January

• Pricing via:

1. Normal approximation.

2. ‘Burn’ analysis – 66 years of data.

3. Monte Carlo simulations

Pricing Example

Period: January Measure: Cumulative CDD

Exercise Prices: 170 / 180 / 190 / 200 CDD’s Tick:: $100,000 /CDD Location: Sydney Airport (Kingsford Smith)

Page 30: Weather Derivative Pricing and Risk Management Applications · Much less common than temperature-based derivatives. Market was born out of temperature exposure. ‘Discreetness’

• Stochastic form:

• Euler approximation - discrete

Monte Carlo

∫∆−∆− +−+=

t

s

tt

ott dWeeTTTT ττγγ σ.).( 0

Z.).(1 σγ ++−=−+dt

TdTTTT

t

ytt

8.00

10.00

12.00

14.00

16.00

18.00

20.00

22.00

24.00

26.00

28.00

30-S

ep

14-O

ct

28-O

ct

11-N

ov

25-N

ov

9-D

ec

23-D

ec

6-J

an

20-J

an

3-F

eb

17-F

eb

3-M

ar

17-M

ar

31-M

ar

14-A

pr

28-A

pr

12-M

ay

26-M

ay

9-J

un

23-J

un

7-J

ul

21-J

ul

4-A

ug

18-A

ug

1-S

ep

15-S

ep

29-S

ep

de

g C

Simulation

Page 31: Weather Derivative Pricing and Risk Management Applications · Much less common than temperature-based derivatives. Market was born out of temperature exposure. ‘Discreetness’

Pricing Example

Pricin g C om p ariso n - Janu ary

$0

$100,000

$200,000

$300,000

$400,000

$500,000

$600,000

170 180 190 200Exe rcise (CDD)

Op

tio

n P

ric

e

'B urn' A nalys is M onte Carlo S im ulation Norm al A pprox im ation

Sydney Airport

January

Method 170 180 190 200

'Burn' Analysis $473,306 $268,763 $137,865 $59,582

Monte Carlo Simulation $489,044 $230,479 $90,848 $13,990

Normal Approximation $463,670 $288,627 $167,993 $91,012

Exercise (CDD)

Page 32: Weather Derivative Pricing and Risk Management Applications · Much less common than temperature-based derivatives. Market was born out of temperature exposure. ‘Discreetness’

4. Rainfall Modelling

Page 33: Weather Derivative Pricing and Risk Management Applications · Much less common than temperature-based derivatives. Market was born out of temperature exposure. ‘Discreetness’

• Annual

• Monthly

Rainfall Correlations Ye a rly R a in fa l l C o rre la tio n

y = 1 .0088x + 128 .21

R 2 = 0 .8846

0

500

1000

1500

2000

2500

500 700 900 1100 1300 1500 1700 1900 2100

S yd . A irp o rt

Ob

serv

ato

ry

0.9

0.91

0.92

0.93

0.94

0.95

0.96

0.97

0.98

Jan Feb Mar Apr May June July Aug Sep Oct Nov Dec

Co

rrela

tio

n

Monthly Rainfall Correlation

Page 34: Weather Derivative Pricing and Risk Management Applications · Much less common than temperature-based derivatives. Market was born out of temperature exposure. ‘Discreetness’

Compound Model – size & frequency.

�Frequency: Markov Chain.

�Size: Gamma distribution (4 segments).

Transition probabilities:

Modelling Rainfall

Rain No rain

Rain 0.55 0.45

No rain 0.28 0.72

Page 35: Weather Derivative Pricing and Risk Management Applications · Much less common than temperature-based derivatives. Market was born out of temperature exposure. ‘Discreetness’

Actual vs Expected Frequency – Sydney Airport

Frequency Simulation

� Errors are greatest in winter - i.e. errors not proportional.

� Clearly defined seasonal patterns.

0

0.1

0.2

0.3

0.4

0.5

0.6

0.7

0.8

0.9

1

1

15

29

43

57

71

85

99

11

3

12

7

14

1

15

5

16

9

18

3

19

7

21

1

22

5

23

9

25

3

26

7

28

1

29

5

30

9

32

3

33

7

35

1

36

5

Da y of Year

Ra

in F

req

ue

nc

y

f_rainf_norainPoly. (f_ra in)

Page 36: Weather Derivative Pricing and Risk Management Applications · Much less common than temperature-based derivatives. Market was born out of temperature exposure. ‘Discreetness’

Magnitude

Rain t-1 No Yes

Average 3.74 7.20

StdDev 6.21 12.23

Max 79.0 182.1

Min 0.1 0.2

Average 6.43 13.89

StdDev 11.22 21.46

Max 132.6 216.2

Min 0.2 0.2

No

Yes

Rain t+1

Gamma distribution parameter values

NRN RRN NRR RRR

alpha 0.58 0.45 0.47 0.49

beta 19.32 12.09 13.07 6.39

�4 segments conditional on t-1 and t+1.

�Fit 4 Gamma distributions

Gamma Distributions

0.00

0.05

0.10

0.15

0.20

0.25

0.30

0.35

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

4.5

5.0

5.5

6.0

6.5

7.0

7.5

8.0

8.5

9.0

9.5

10.0

Magnitude (m m )

Pro

po

rtio

n

NRN RRNNRR RRR

Page 37: Weather Derivative Pricing and Risk Management Applications · Much less common than temperature-based derivatives. Market was born out of temperature exposure. ‘Discreetness’

Actual vs Expected Magnitude – Sydney Airport

Magnitude

� Close Gaussian fit.

� Clearly defined seasonal patterns.

Actual vs Expected: No rain / Rain / No rain

0

50

100

150

200

250

300

350

400

2 4 6 8 10 12 14 16 18 20 22 24 26 28 30 32 34 36 38 40 42 44 46 48 50 52 54

M agnitude (mm)

Fre

qu

en

cy

Actual Model

Page 38: Weather Derivative Pricing and Risk Management Applications · Much less common than temperature-based derivatives. Market was born out of temperature exposure. ‘Discreetness’

Actual vs Expected Magnitude – Sydney Airport

Simulation

Feb .

0

1

2

3

4

5

6

7

8

0

10

20

30

40

50

60

70

80

90

10

0

11

0

12

0

13

0

14

0

15

0

16

0

17

0

18

0

19

0

20

0

21

0

22

0

23

0

24

0

25

0

26

0

27

0

28

0

29

0

30

0M odelA c tual

Page 39: Weather Derivative Pricing and Risk Management Applications · Much less common than temperature-based derivatives. Market was born out of temperature exposure. ‘Discreetness’

� New Markets:

• Australian market practically non-existent – agricultural based economy.

• Must promote to seek out suitable counter-parties.

• Improve product design – reduce basis risk.

• Centralised data recording methodologies – Europe in particular.

� New Interest:

• Hedge funds – attracted to immature market.

• Diversification tool – minimal correlation to debt and equity markets.

• Weather-based indexed insurance contracts.

Where to from here?