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Hedging Corporate Revenues with Weather Derivatives: A Case Study

Master of Science in Banking and Finance - MBF Master’s Thesis

Antoni Ferrer Garcia Franz Sturzenegger

Universit´ de Lausanne e Ecole des Hautes Etudes Commerciales HEC - 2001

Abstract This paper searches for the implications in the use of a new generation of financial derivatives known as Weather Derivatives as a form of hedging future corporate revenues. According to the US Department of Commerce about 22 per cent of the US$ 9 trillion GDP in the United States is sensitive to weather. This figure supports the growth in the market that started at the beginning of the 1997s. Likewise, it is estimated that already some 1,800 deals worth roughly US$ 3.5 billion have been transacted in the U.S. An estimated 70 per cent of all businesses face weather risk which extends across geographic and market borders. The current weather derivatives market is still illiquid and several pricing models are being used by financial institutions. On this paper we show the characteristics, pricing models and hedge strategies about such new contracts. Our case study has been done within a multinational corporation that we will be here called XYZ to preserve its confidentiality.

Acknowledgments
Before starting, we would like to thank all the people that with their support and understanding have contributed to make this master’s thesis somehow better: Mrs. F. Kafader of Kundendienst-Account, Swiss M´ t´ o, Prof. Dusan Isakov ee (HEC - Gen` ve), Mr. J¨ rg Tr¨ b (Swiss Re-insurance), Robert Dischel, Melanie e u u Cao and Jason Wei. Several institutions that have supported us with data, advice or knowledge about the weather derivatives markets: Enron, Aquila Energy, AC Nielsen, Migros, and Koch Energy Trading. Special thanks to company XYZ since it was their idea to write about this topic. It is also theirs most of the data contained on this thesis. With their help and that of Mr. Lagger and Mr. Silen, we started our research. Special thanks, also, to professor Didier Cossin to direct our thesis and to give academical support to such an interesting topic. Last but not least, thanks to our family, girlfriend and friends - Manuel Kast, Dr. Alexander Passow, Beatriz Rueda - that certainly have helped us during the whole MBF Program and during the preparation of this thesis. This thesis is dedicated to them.

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Preface
In today’s financial markets, derivative instruments have certainly a granted place on corporate risk management as a way to insure against or hedge business hazards. Derivatives are financial instruments whose values depend on the value of other securities known as the underlying. Those underlyings are often traded assets such as stock, commodities, currencies, bonds but can also be non-traded assets such as stock index. Futures and options are actively traded on major exchanges while forward and swap contracts are evenly traded outside exchange by financial institutions in the over-the-counter market (OTC). Since the study of Black and Scholes, ‘The Pricing of Options and Corporate Liabilities’ and Robert Merton,‘The Theory of Rational Option Pricing’, we have seen an astonishing growth in derivative markets and in the development of more complex instruments that simple plain-vanilla options, such as Asian Options, Lookback Options, Barrier Options, Catastrophic Bonds and others. Nowadays, a new class of derivative securities has been created to offer corporate managers an instrument to hedge their firms against climate conditions’ hazards. They are known as Weather Derivatives and are designed to minimise or avoid the risks due to changes in weather conditions. On the other hand, several questions have been raised for why corporate managers should hedge their business and on what are the consequences of the use of derivatives as a form to offset undesired risks. Sometimes, instead of using derivatives for hedging purposes, managers have traditionally used...
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