Bob Dischel  Dr. Dischel is a partner in Weather Ventures Ltd in the US and Global Weather Exchange in Europe, where he provides meteorological analysis and forecasts, and develops risk management programs for weather-sensitive enterprises . Bob left a position as a Managing Director in the Portfolio Department of a multi-billion dollar US Insurer to begin his weather risk market activities in 1997. He is certified by the American Meteorological Society as a Consulting Meteorologist and is a member of the National Council of Industrial Meteorologists. The weather risk market -
Weather is bigger than the Fed. Weather-indexed derivatives link cashflows to the weather. These derivative securities grow in value only with the occurrence of weather events measured at specific sites over periods of a few weeks or months. While the weather affects economic events on many scales - certainly business performance - economic events do not affect the weather or the final value of a weather derivative. If there is a correlation between weather derivatives and other markets, the driver is the weather. -
The right kind of weather forecast is never wrong: unfortunately , it is never entirely correct. Meteorologists prevaricate as they skirt simple statements, as I just did. Forecasters must hedge their opinions because weather is changing even as we watch, so the right kind of forecast is one that offers the odds of coming events. For example, forecasting an 80% chance of rain also allows for a 20% chance of no rain, and a forecast of rain amounts is even better. Chances are good that the real event was represented within the forecast range of events, but the winning forecast will be the one that gave the real event a high probability. -
People's opinions may rule weather trading but Mother Nature and Father Time decide who wins. Weather derivative prices change as each new seasonal forecast is issued and market players use this new information to tilt the odds in their favor. The usefulness of a seasonal forecast depends on many conditions, including global events like El Nino. But weather, as we all know, can be uncertain , so winning is not just about forecasts - it's about estimating the probabilities of future weather. We can choose to look forward or backward to form opinions, but the weather event that actually happens establishes who pays - and this is not open to opinion. -
A one- season visit to the weather market is a crapshoot. Enter the weather market only for the long term. Weather and climate are moving targets ensuring year-to-year volatility. Market players struggle to understand how much last season's average weather says about this coming season's weather. The climatologist (and any statistician) knows that in the absence of a confirmed trend, decades of history tell more about the future than a few recent years. It is simplistic to look only at the warmer-than-normal few years of the 1990's when last winter (2000-2001) smashed US long- term records for low temperatures . Was this a broken trend or increasing variability? -
Mother Nature may come uninvited to the company picnic but you can keep her out of the shareholder's meeting. Most weather-sensitive businesses bet on the weather even though they don't have to, as when they don't hedge the weather. For them, not hedging keeps weather risk high. When a business hedges its weather exposure well, it 'takes the weather bet off the table' and is free to focus on its business competencies; these usually do not include managing weather. Now that there is a choice, will equity analysts and shareholders continue to accept 'bad weather' as an explanation for poor company performance? -
Resist taking money off the table from an in-the-money position if it was meant as a hedge. End-users should always hedge a weather exposure if it is economical to do so, even if the forecast indicates a favorable season. First, it surprises no one that forecasts can be wrong. Second, weather hedging can free up capital reserves for important activities like growth or better service to customers. Having hedged for protection, the hedge becomes valuable only in an adverse season, precisely the event that required protection. If the hedge is winning, it is because the business is losing to the weather. If it's working - don't fix it. -
Diversity in weather greatly exceeds diversity in weather derivatives. Today's end-users, mostly energy producers and distributors , are naturally short temperature in winter and long temperature in summer: cold winters and hot summers generate sales. To hedge their natural position against mild seasons, they need to lengthen temperature in winter (a temperature call) or shorten temperature in summer (a temperature put). Absent natural counterparties, the market absorbs these hedges into risk capital. When a mild season is forecast, end-users and everyone else want the same side of the market, driving prices up. If prices get too high some end-users mistakenly choose not to hedge, leaving the speculators, all wanting to bet the same side of the weather odds. This lack of diversity won't change until new products, specifically considering precipitation, bring end-users from other sectors of the economy. -
Price is important, but value is more important. End- user or portfolio manager, your view of value is based on your weather exposure, your risk preferences and your opinions on future weather. The market price and your perspective on the value of a weather derivative can be quite different. If the value of a derivative to your enterprise exceeds the market price - go for it. However, remember that the weather market is not yet a liquid market and often the position you take is yours until expiration, so if you pay too much, you tilt the probability of a favorable outcome away from your hand. -
Black and Scholes pricing is valuable in many markets, but in weather, it is simply wrong. The basic idea of the Black-Scholes analysis is to hold a position in an option that is equal and opposite to a position in the asset from which the option's price is derived: to build a risk-neutral portfolio. We cannot do this because the weather on which the derivative's price is based cannot be owned. This isn't all bad. It means no one can manipulate the market by cornering the weather, and portfolios can still be balanced with other assets, just not with the weather itself. -
It can rain on one side of the street and not on the other - so what? Climate is geographically diverse leading to weather basis risk. Site-to-site correlations break down with increasing distance, the presence of mountains , coastlines, and of course, cities. This geographic basis risk is troublesome for the end-user looking to hedge a local business, but it makes opportunity for a speculator for the very same reason: weak correlations offer diversity. As to the rain across the street - how much will the histogram of rain measured over a month on one side of the street look like the histogram for the other side? Very much like it, I think. bobdischel@WeatherVentures.com, www.WeatherVentures.com 'The pain people feel from losing $100 is much greater than the pleasure they get from winning $100. Be careful that this does not lead you to cling on to losing investments in the hope that they'll return to profit.' ”Gary Belsky |  |
