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For Sale: Hurricanes

by J.H. Freeman
Jan 15, 2009


HURRICANES

J.H. Freeman/MEDILL

Weather-trading volume has surged in the past three years at CME Group

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After a successful 2008 season for hurricane futures and options, which totaled $400 million, CME Group Inc. announced this week that it will extend trading to encompass the entire year from Jan. 1 to Dec. 31, instead of its former period from June 1 to Nov. 3.

According to a report sponsored by CME Group and a weather-related risk and information company, Storm Exchange Inc., as of March 2008 weather-trading volume (which comprises hurricanes, frost, snowfall, temperature and precipitation indices) rose by nearly one million contracts, up from 798,000 in 2007. As of Jan. 13 of this year, contracts traded total 12,096.

With evident climate change, weather unpredictability and the credit-crunch all on the minds of investors, heads are turning towards alternative hedging opportunities. In these uncertain times, weather-related risk is a centerpiece of some companies’ strategies.

“The extension [of the trading period] was in response to our customers. They told us that if we listed the hurricane contracts sooner, they would be able to transfer their risk sooner,” said Michael Shore, associate director of interest rate and alternative investments at CME Group.

Unlike other exchange-traded commodities, which tend to draw companies in a specific industry like agriculture, weather derivatives have attracted all sorts of buyers and sellers.

Beginning in the late 1990s with energy and utility companies, the market has now expanded to insurance and reinsurance, hedge funds, pension funds and state governments. Retailing, entertainment and sports enterprises have all expressed interest as well.

Rene Carmona, professor of engineering and finance at Princeton University, elucidated this point: “I remember this story about an amusement park in Paris which bought a rainfall derivative in case it rained and people didn’t show up.”

So what happens if it rains? What happens if it hurricanes?

Insurance companies, for example, hoping to hedge against the potentially catastrophic damage a hurricane might incur, would assess their risks and then buy Hurricane Event contracts at a specific strike price, such as 10 CHI. The CHI, or Carville Hurricane Index, serves as a kind of Richter scale for measuring the damage a hurricane inflicts on a company, and is the official tool used by CME Group to settle its contracts.

If a hurricane hits it is given a CHI value formerly recognized by the insurance company and the counterparty, and the contract is cash-settled. The counterparty reaps the benefits if the hurricane doesn’t hit at all or registers below the CHI level of the contract. It’s one of the few agreements in life that protects all people involved-- except, of course, those who are in the very path of destruction.

The first recorded weather derivative contract occurred in 1997 between Koch Industries Inc. and Enron Corp. Based on a temperature index for Milwaukee, the over-the-counter (not exchange-traded) deal stipulated that Enron would pay Koch $10,000 for every degree the temperature fell below normal during the winter of 1997-1998, while Koch would pay Enron $10,000 for every degree above normal.

The relatively young market has matured since then, and the Chicago Mercantile Exchange (now CME Group after it merged with the Chicago Board of Trade) standardized the market in 1999. Today, CME offers contracts on indices of temperature and precipitation in 24 U.S., 10 European, two Asian-Pacific, and six Canadian cities.

But because of the inability to forecast catastrophic weather events well into the future, the hurricane market may never be as voluminous as other exchange-traded derivatives.