W W Weathering the storm vs. your financial Weathering the storm - PowerPoint PPT Presentation

W W Weathering the storm vs. your financial Weathering the storm vs. your financial th th i i th th t t fi fi i l i l bottom line – bottom line – hedging weather hedging weather- -related related risks in the viticulture industry with risks in the viticulture industry with i k i k i i th th iti iti lt lt i d i d t t ith ith weather contracts weather contracts Don Cyr (CCOVI Fellow), Martin Kusy, Faculty of Business Don Cyr (CCOVI Fellow), Martin Kusy, Faculty of Business and and Tony Shaw (CCOVI Fellow), Department of Geography Tony Shaw (CCOVI Fellow), Department of Geography Brock University Brock University CCOVI Lecture Series CCOVI Lecture Series – – April 2010 April 2010

Agenda Agenda Agenda Agenda  Weather  W W Weather derivatives (contracts) th th d i derivatives (contracts) d i ti ti ( ( t t t ) t )  Weather risks faced by the viticulture industry Weather risks faced by the viticulture industry  Hedging the  Hedging the Hedging the risks Hedging the risks risks of risks of of icewine of icewine icewine production icewine production production production  Bioclimatic Bioclimatic index index risk risk  Harvest  Harvest Harvest rainfall Harvest rainfall rainfall rainfall  Winter Winter injury injury  Future research Future research Future research Future research

Weather Derivatives Weather Derivatives Weather Derivatives Weather Derivatives  Financial securities such as swaps and options with payoffs  Financial securities such as swaps and options with payoffs Financial securities such as swaps and options with payoffs Financial securities such as swaps and options with payoffs contingent on weather contingent on weather – –related variables such as related variables such as  average temperature average temperature  heating and cooling degree days heating and cooling degree days  maximum or minimum temperatures maximum or minimum temperatures  Frost days Frost days Frost days Frost days  Precipitation (rain or snow) Precipitation (rain or snow)  humidity humidity  sunshine sunshine hi hi

Fundamentals Fundamentals Fundamentals Fundamentals Five essential elements to every weather derivative contract: Five essential elements to every weather derivative contract: the underlying weather index or variable. the underlying weather index or variable.   the period over which the index accumulates, typically a the period over which the index accumulates, typically a th th i d i d hi h th i d hi h th i d l t l t t t i i ll ll season or month. season or month.  the weather station reporting the weather variable. the weather station reporting the weather variable. p p g g  the dollar value attached to each move of the index value the dollar value attached to each move of the index value (Tick Tick Value). Value).  the reference or strike price of the underlying index. the reference or strike price of the underlying index.

Potential for Use Potential for Use Potential for Use Potential for Use Potential for use in many sectors of the economy to hedge Potential for use in many sectors of the economy to hedge y y y y g g the risks of adverse weather conditions to net revenues. the risks of adverse weather conditions to net revenues. – 15% of industrialized economy is weather sensitive. 15% of industrialized economy is weather sensitive. (Hanley, 1999) (Hanley, 1999) – 20% to 30% of US GDP is exposed to weather risk. 20% to 30% of US GDP is exposed to weather risk. (Dutton (2002), Larson (2006), Weatherbill (2008)) (Dutton (2002) Larson (2006) Weatherbill (2008 (Dutton (2002) Larson (2006) Weatherbill (2008)) (Dutton (2002), Larson (2006), Weatherbill (2008 )) )) – world’s production output could increase by greater world’s production output could increase by greater world s production output could increase by greater world s production output could increase by greater than US $250 billion if weather risks were hedged than US $250 billion if weather risks were hedged effectively effectively

Not Insurance Contracts Not Insurance Contracts Weather derivatives differ substantially from insurance Weather derivatives differ substantially from insurance .  Insurance Contracts I I Insurance Contracts C C – generally intended to cover damages dues to infrequent high generally intended to cover damages dues to infrequent high- -loss loss events. events. – moral hazard playing a significant role. moral hazard playing a significant role. – Require the filing of a claim and proof of damages. Require the filing of a claim and proof of damages.  Weather Derivatives  Weather Derivatives Weather Derivatives Weather Derivatives – limited loss, high probability events such as adverse weather limited loss, high probability events such as adverse weather conditions. conditions. – designed as a “hedge” on a weather d designed as a “hedge” on a weather variable. d i i d d “h d “h d ” ” th th variable. i bl i bl – only requirement being an observable objective weather variable only requirement being an observable objective weather variable agreed upon by both parties. agreed upon by both parties. – More transparent in many cases, than insurance contracts. More transparent in many cases, than insurance contracts.

Growth of Weather Derivatives Growth of Weather Derivatives Growth of Weather Derivatives Growth of Weather Derivatives First appeared in Fi Fi First appeared in 1996: Contract t t d i d i 1996 C 1996: Contract between Enron and 1996 C t t t t b t b t between Enron and E E d d Florida Power and Light. Florida Power and Light.  Growth has been impressive: Growth has been impressive: G G h h h h b b i i i i – Market Size: $500 million in 1998 to Market Size: $500 million in 1998 to $15 $15 billion in billion in 2008 2008- -09. 09. (Weather Risk Management Association) (Weather Risk Management Association) Temperature related contracts comprise 80% of the market with Temperature related contracts comprise 80% of the market with energy industry the major participant. energy industry the major participant. energy industry the major participant. energy industry the major participant. – Forecasted to be a $200 billion dollar market within five years. Forecasted to be a $200 billion dollar market within five years. (Weather Risk Management Association) (Weather Risk Management Association) ( ( g g ) )

Growth of Weather Derivatives Growth of Weather Derivatives Two Types of Contracts: Exchange Traded and OTC. Two Types of Contracts: Exchange Traded and OTC. Chicago Chicago Mercantile Exchange Standardized Contracts. Mercantile Exchange Standardized Contracts.  Commenced trading in 1999. Commenced trading in 1999. – Standardized contracts based on the average daily St St Standardized contracts based on the average daily temperature. d d di di d d t t t b t b d d th th d il t d il t temperature. t t – Major US, European (2003), Asian/Pacific (2004) Major US, European (2003), Asian/Pacific (2004) , Canadian , Canadian (2006) (2006) and and Australian (2009) cities. Australian (2009) cities. – Cooling Degree Days (CDD) = max [T Cooling Degree Days (CDD) = max [T Cooling Degree Days (CDD) = max [T Cooling Degree Days (CDD) = max [T i – 65 65 o F( or 18 65 o F( or 18 65 F( or 18 o C) 0] F( or 18 o C), 0] C) 0] C), 0] . – Heating Degree Days (HDD)= max [65 Heating Degree Days (HDD)= max [65 o F(or 18 F(or 18 o C) C) – – T i , 0] , 0] . . – Cumulative monthly or seasonal degree Cumulative monthly or seasonal degree days. days. – Other contracts are written on snowfall Other contracts are written on snowfall (New York, Boston, Chicago Other contracts are written on snowfall Other contracts are written on snowfall (New York Boston Chicago (New York Boston Chicago (New York, Boston, Chicago Minneapolis, Detroit) and Minneapolis, Detroit) and frost free days. frost free days.

Over the Counter (OTC) Market Over the Counter (OTC) Market Over the Counter (OTC) Market Over the Counter (OTC) Market  Privately negotiated, individualized agreements made Privately negotiated, individualized agreements made between two parties. between two parties.  All All Allows for the hedging of Non- Allows for the hedging of Non f f th h d i th h d i f N f N -standardized standardized situations and t t d d di di d it d situations and it ti ti d d risks. risks. – Specialized needs relating to terms of the contract. Specialized needs relating to terms of the contract. p p g g – Specific location for variable measurement. Specific location for variable measurement.  Liquidity not as great Liquidity not as great – – underlying variable not traded. underlying variable not traded.  Price for contract must be agreed upon by the two parties. Price for contract must be agreed upon by the two parties. i i f f i i