Financial Instruments to Weatherproof Corporate Earnings

Abstract

THE JOURNAL OF ALTERNATIVE INVESTMENTS 95 I t is estimated that nearly 20% of the U.S. economy is directly affected by weather.* Just as the risk in interest rates, equities, and foreign exchange can be hedged through the use of options and futures, now there are tools to manage risk arising from extreme movements in weather. Since the launch of Chicago Mercantile Exchange temperature-related weather derivatives contracts in 1999, these risk management products represent today’s fastest-growing derivative market. The Weather Risk Management Association (www.wrma.org) website provides an open forum for weather risk management industry participants to address the issues, allows them to network among their peers, announces yearly WRMA’s annual conference, and provides a gateway of information for the general public in this burgeoning field of risk management. The site also addresses matters related to weather risk management in Europe, Asia, and South America. The WRMA website is organized into five sections. The first part introduces the WRMA and its goals, highlights current trends in the industry, and calls attention to forthcoming conferences. The second part explains the concept of weather risk management and the reasons to hedge not only the unit price variation but also the unit volume variance, and describes the weather risk management product class including caps, floors, collars, and swaps. The third part provides information on how to become a member, as well as a list of members, and points up benefits of membership such as receiving a free WRMA newsletter, enjoying discounts on books and magazines published by Risk Publications, and participating in member-only committees. The case studies shed light on the benefits of weather derivatives by using concrete examples. The “industry news” section, the fourth part, includes a long list of links to reports and newswires on other websites. The last section provides links to related sites such as the National Center for Environmental Prediction and Center for Ocean-Land-Atmosphere Studies. The weather risk management arena is constantly changing. By the time you read this review, in addition to existing monthly futures and options on futures weather contracts, the Chicago Mercantile Exchange will have introduced seasonal weather contracts covering May through September for summer and November through March for winter for three cities in the United States starting May 26, 2003. The WRMA website is the starting point for risk managers who want to discover the new tools available to hedge the weather risks on corporate earnings.