Why do they call these contracts derivatives? Where is the optionality in these contracts?
Weather derivatives structures commonly used are:
i) cap - a call option;
ii) Floor - a put option;
iii) Collar - a put and a call option, usually with little or no premium; iv) Swap - a derivative with a profit and loss profile of a futures contract v) Digital option - an option that pays either a predetermined amount if acertain temperature or degree day level is reached, or nothing at all in other case.
A business with weather exposure may choose to buy or sell a futures contract, Which is equivalently to a swap such that one counterparty gets paid if the degree Day over a specific period are greater than the strike level, and the other party gets paid if the degree day over that period are less than the strike. A business may also choose to write an option. A heating oil retailer may feel that if the winter is very cold they will have high revenues - so they might sell an HDD call. If the winter is very cold, the retailer can afford to write the option and pay out with higher than normal revenues.
Weather trading is much different than other found on the financial and commodity market. Firstly, there is no tradable underlying instrument. Trades are referenced to notional indexes, potentially of any weather variable, for any location, over any time period (Nicholls, 2005). Also, weather market combines characteristics of insurance and derivatives markets. Weather derivatives generally cover low-risk, high-probability occurrences like temperature fluctuations. Therefore, they differ from insurance contracts that protect policyholders against low-probability catastrophic storms (Ceniceros, 2006).
A generic weather option can be formulated by specifying the following parameters (Alaton et al., 2002): 1)The contract type (call or put); and the contract period;Typical contracts are written on cumulative HDD/CDD structured by options,for a given period.HDD...
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