Critique: Increasing Importance of the Weather Man

After reading Jessica L’s post on weather derivatives I had some mixed feelings on the whole concept. I agree with her that there is still some uncertainty with pricing this type of financial tool. With very uncertain climate conditions it is a good idea to hedge by using this financial tool. Using this derivative will insure a farmer’s profitability and reduce risk associated with adverse or unexpected weather conditions according to wikipedia. However, the buyer of the derivative could not be fully protected since the contract is triggered on a regional basis rather than on an individual basis.

Also there are many other companies that can use weather derivatives to protect seasonal profits. These companies may be theme parks, sports teams, or power companies that depend on the weather to remain profitable. Jessica states that “98-99% of derivatives traded are based on temperature.” Since temperature is related to precipitation the derivative is triggered by one of the two. So pricing this model would be easy using stochastic processes, where probabilities are determined by which state you are in. So the insurer should study the probability for consecutive rainy and rain free days. Based on this the model to price this type of derivative should be very complex, since you have to consider each day until maturity.

The insurer should also account for the land, the crop being grown, and the location. If either one of these is unsuitable for favorable crop growth then the price of the derivative should be higher than some one buying a derivative in a more favorable climate for a crop. For example a weather derivative for an orange grove in Florida will be cheaper than for an orange grove in New York due to more favorable conditions.

The Chicago Mercantile Exchange currently trades weather derivative contracts for 18 cities in the United States, nine in Europe, six in Canada and two in Japan. According to investopedia, weather risk is also unique in that it is highly localized, it cannot be controlled and despite great advances in meteorological science, still cannot be predicted precisely and consistently. If you buy a weather derivative in a city that is somewhat close to your farm, you may have different weather conditions even though you are so close. As we stated in class one person may gain or lose depending on what happens in the region around the city you are hedged against. So these contracts are not fully customized to every local farmer’s needs, they are only protected when the city that is insured has bad weather conditions.

Links:
http://jlewis45rmiblog.blogspot.com/

http://en.wikipedia.org/wiki/Weather_derivatives

http://www.investopedia.com/articles/optioninvestor/05/052505.asp

http://www.usatoday.com/weather/forecast/2008-06-09-weather-derivative_N.htm