Hi all welcome to this session on Commodity
Derivatives and Risk Management and we will
continue with the discussion on Weather derivatives.
And if you recall we had started discussing
about HDD contract and CDD contract which
are listed at Chicago Mercantile Exchange,
and this is the only exchange in the world
which have derivative contracts and also another
important point which I must mention at this
point of time that couple of years back CME
had many other types of weather derivative
contracts like hurricane, contracts and hurricane
contracts on rainfall, snowfall etc.
But because of lack of interest this CME has
discontinued with these weather derivatives,
however very briefly we will be discussing
different aspects of this rainfall and snowfall
and hurricane derivative contracts just for
sake of our knowledge and we will also be
discussing little more on this HDD and CDD
contracts which are continue to be offered
at CME exchange.
So let us go to our discussion on HDD and
CDD if you recall a day will be treated as
a heating degree day a day requiring heating
degree day will be Max [0 coma base temperature
minus T i] similarly a day which will be treated
as a cooling degree day you will have a Max
[0 comma T i minus base temperature] and this
base temperature values are given by the exchange
and also another important point about this
heating degree day or cooling degree day contract
is always with respect to a specific location.
USA is a very big country so temperature varies
from location to location on a given day.
So if a wheat farmer from Minneapolis is interested
to take wheat futures is interested to take
futures contract on temperature it must be
interested or it would be keen on taking the
temperature contract related to Minneapolis,
so it will not be interested to take temperature
related derivative contracts with respect
to other location of USA.
And let us quickly discuss about what we from
where we stopped last session, so wheat farmer
has a fear of colder winter, so if winter
is going to be very cold the quality of wheat
is not going to be good, so it is interested
in mitigating this risk by entering into weather
derivative, so what is the farmers fear?
Farmer fears that if there are more number
of days requiring HDD heating degree days
the farmer is going to incur loss, so if HDDs
are more it should get benefit from the futures
contract.
So it enters into a long futures contract
and depending upon the actual value of HDD
the farmer may get money or pay money.
So if total HDD value for that given month
closes at 690 and the farmer had taken the
long futures as 625 and in that case the counter
party to the farmer will be 130000 to the
farmer and in the other case when the HDD
closed at 603 the farmer is going to pay 44000
to the counter party.
Now let us take another example of how if
this weather contract can be used by eh another
business.
Let us say a hot coffee chain sells in summer
month suppose the chain fears a hotter summer
in coming July and decline in sales this company
is expecting that sales is going to decline
and every year sales declines in the month
of July because it is a summer month and but
this year it is expecting that the summer
is going to be unusually hotter and the sales
is going to be even going down even more than
the other years.
So how this particular coffee chain will be
able to utilise the derivative contract weather
derivative contract to mitigate the risk.
So my question to you is that whether it will
take HDD contract or CDD contract and whether
it will take long futures or short futures?
Ok, the answer to my question is, this company
will take CDD and it will take again long
futures position that is if there more number
of cooling degree days, so if the summer is
hot enough than you will have more number
of cooling degree days.
So if there are more number of cooling degree
days this company is going to incur loss because
many people will not be interested to to drink
hot coffee.
So if there are more number of cooling days
it would be incurring loss from its revenue
and it would be incurring loss from the coffee
sales so it should be compensated from the
from the futures contract.
So it will be entering into a long futures
contract so let us take the CDD value to be
the price at which it entered into long futures
or the value at which it enters entered into
long futures position is 1068 and his fear
comes to comes true and the or the companies
fear comes true and it is unusually hotter
and requiring people to requiring people to
switch on their ACs and many people did not
venture into venture to drink hot coffee.
So in that case CDD value closed at 1090,
so this company will receive cash from the
counter party which is to the tune of 66000.
Similarly let us say companies is not right
in its expectation regarding more number of
cooling degree days so this July month the
number of cooling day days was little lesser
so the company this CDD closed at a value
of 1020 and so it is a colder summer month
and it will be paying cash to the counter
party to the tune of 144000.
Now besides this HDD and CDD contracts CME
also offers contracts called CAT that is Cumulative
Average Temperature Contract, if you recall
the T i is calculated by the by taking average
of dailies 1 days maximum temperature and
the minimum temperature, so in case of a CAT
contract that is Cumulative Average Temperature
contract the T i is sum is the average of
the every hourly temperature.
So independent party has to take record the
hourly temperature and that hourly temperature
divided by sum total of 24 hours temperature
divide by divided by 24 keeps the CAT for
that day and CAT for the month will be obviously
sum total of the CAT of the day and accordingly
this buyer and seller will be able to take
call on this CAT values and depending upon
the final settlement CAT values the either
long futures will pay money to the short future
or vice versa.
Exchange also offer contracts on HDD option,
so you can have traders take into long call,
short call, long put or short put options
and exactly the same way in case of a call
the exercise value of the HDD or CDD is already
pre-decided and if it is a long call option
if actual HDD is more than the exercise HDD
value the long call option position holder
gets money from short call option position
holder.
So it is exactly like any other option contract
only the underlying gets decided from the
value of the CDD or HDD.
Uh CME at one point of time as I mentioned
it had frost, snowfall and rainfall index
futures contract on frost, snowfall and rainfall
index shows at a some specific location let
us say Amsterdam airport USA also had contracts
which is derivatives contract for some specific
locations in Europe.
So let us say at Amsterdam airport if the
snowfall is beyond certain value the buyers
and sellers will be able will be paying money
to each other depending upon the snowfall
recorded at specific location, as I mentioned
it could be Amsterdam airport.
The specific locations are very clearly mentioned
so if I am entering into a futures contracts
or futures contract or option contract, I
know this particular weather contract is respect
to which location and which weather parameter.
So if it is snowfall then if it is a snowfall
contract but for which location, is it New
York, is it eh any other city in USA or it
could be any city in Europe, so depending
upon the city or location as a buyer or seller
I will be taking position for that particular
contract for that city.
As also as you must by this time maybe understanding
that this some independent party has to be
interested with calculation of this index,
so what is going to be the snowfall index.
How do you measure the snowfall because as
soon as the snowfalls it melts, so how do
how there has to be some scientific way of
recording snowfall, so how do you measure
also the frost, so if the revert is a how
do you what is the difference between frost
and snowfall.
So all these factors were incorporated into
the contract specification and let us say
for a snowfall index there is a way independent
party will measure the snowfall at a specific
location and depending upon that value either
long futures party will pay to the short futures
positions holder or vice versa.
And I am not going into this detail because
this contracts are not no more available for
trading, so however the contract specifications
are it is available just for the sake of information,
if you are more interested you can download
this contract information and try to understand
more about this.
in Indian context we have multi commodity
exchange preparing and reporting rainfall
index for 3 places, I will just take you through
this detail but there is no derivative contract
available for trading on this rainfall indices,
so only the index values are reported as of
now, maybe as the time goes by and there are
enough trader who are interested to trade
in this rainfall contracts this futures contracts
on rainfall can be made available by these
Indian exchanges.
So you have this is the index value for Mumbai,
this is the index value for Indore and this
is the index value for Jaipur.
So these are the different values given so
what are the normal values index normal values,
normal value for Mumbai is 1950 and please
note that this index gets calculated only
for rainy months, so rainy season it is never
get calculated for other non-rainy season.
So in the month of June so let us see for
Bombay so 28 June what is the value of this
rainfall index, rainfall index value for Mumbai
is 2079 and it can be interpreted that it
is more than the normal value of 1950.
So this is just for sake of information, so
if you want to again learn more about how
these indices are calculated and all you can
visit the MCX website.
I would like to also take you through the
hurricane index at one point of time there
is a futures contract on hurricane and hurricane
was available for trading at Chicago Mercantile
Exchange it was very interesting contract
because the moment you say that somebody can
buy and sell hurricane trough a exchange derivative
contract, people give you this incredulous
look that is something wrong with this particular
person, how can somebody buy and sell contracts
on hurricane, how do you measure hurricane?
There has to be some rational and very logical
way of measuring a hurricane when a derivative
contracts will be traded, the underlying value
has to be quantified properly because the
best the best on this quantification payment
and receipt by long futures and short futures
holders are made.
So how exactly hurricane the value of a hurricane
was measured, so there were two indices in
the first initial indices to measure the value
of a hurricane or measure the impact of a
hurricane was known as a Saffir-Simpson index.
Saffir-Simpson hurricane scale which was developed
in 1969 and this based on this assisted scale
National hurricane centre of government of
USA categorises hurricane on a scale of 1
to 5.
So it will be one category one if it has a
wind speed from 119 to 153 and category 5
will be any hurricane which has a wind speed
more than 252 kilometres per hour will be
categorised as a hurricane category 5.
Now based on this Saffir-Simpson hurricane
index subsequently a new index came into you
now into existence that is known as Carvill
hurricane index or CHI, the CHI not only took
into consideration the wind speed it also
took into consideration the radius of hurricane
force wind.
So the wind speed as well the area on which
it is covering or it impact of hurricane is
applicable for a what is the radius of the
area on which the impact of hurricane is felt,
so taking into this these 2 data, so CHI that
is Carvill Hurricane Index was calculated,
so this detail is mentioned here, V is your
maximum sustained wind speed and V 0 is some
based value, similarly you have R 0, R is
your radius of hurricane force wind and R
0 is the base value for R.
So this is how he index values were calculated
but hurricanes are I mean how do which which
hurricane for which hurricane we are calculating
these values.
So hurricane started getting their names.
So 
if you see this one and this particular website
that is World Metrological Organisation has
listed out the name of the different hurricane,
so let me just increase the size.
So the tropical cyclone names worldwide, so
Caribbean Sea, all tropical cyclone which
are emanating from Caribbean Sea, Gulf of
Mexico, North Atlantic sea, so you will have
this will be in 2016 the first hurricane to
come will be named as Alex, the second will
be Bonny, third one will be Collin, fourth
one will be Daniel, so and so forth, 2007,
18, 19, 20, 21.
So all these years sequentially as by as and
when the names the hurricanes will be coming
these will be named and based on this names
or once a hurricane is named, the exchange
used to calculate the value of the hurricane
or then exchange used to inform the status
of the hurricane whether it is a category
1, category 2 and so on so forth and depending
upon when the hurricane becomes little the
impact of hurricane was considered to be more
or the likelihood of the impact of impact
of hurricane is going to be more in terms
of its destructive capability only then the
exchange used to list it for trading.
Suppose there is a category 1 hurricane eh
if Alex starts and in the metrological the
metrological unit of US government says that
eh the Alex hurricane Alex is a category 1
hurricane, then probably not many people will
be interested to buy and sell the derivative
contracts.
So after the sometime maybe 2-3 days and the
hurricane gathers its momentum and it becomes
it shifts from being hurricane category 1
to category 2 or 3 then only the exchange
makes this contract available for trading,
and only that point of time the exchange informs
what is going to be the carvill index and
that information is given to the people and
then buyers and sellers whoever is going to
be list more affected.
And who fear that if the impact of this hurricane
is going to be more and this company is going
to incur loss because of the negative impact
of the hurricane thus company will enter into
a long futures contract.
And if actually the hurricane risk has a company
incurs loss or let me put it other way round,
if let us say a particular hurricane took
index value of 2 or 2.5 when the contract
got listed in by the CME and a particular
company entered into a futures contract on
other value of 2.7.
Now when the hurricane has made a landfall
and on the day of the landfall let us say
the CHI index for that hurricane was 2.9 so
that means this companies fear has come to
true and the hurricane impact is more than
the agreed upon value of 2.7, so this company
is going to get money from the counter party.
Let us say the other way round this company
which has entered into long futures contract
o hurricane Alex at a value of 2.7 and as
the day went by maybe within 3-4 days the
day the landfall happened that day Alex the
intensity of Alex had gone down and other
CHI index came to let us say 1.9, so in that
case this company is going to give payment
to the counter party.
Of course this particular website not only
mentions the hurricanes which are going to
emanate from Gulf of Mexico and Caribbean
Sea it also lists the hurricanes name to be
emanating from other places of the earth.
So you have this is for eh Eastern North Pacific
names you have, Central North Pacific names,
you have Western North Pacific and South China
names, you have Australian names you have
substantial number of North Indian Ocean names,
please see this one, this is if you recall
couple of years back they people used to only
say that this is the a hurricane is going
to come but nowadays people are talking about
hurricane that is a typhoon or a cyclone,
hood-hood last to last year there was lot
of discussion on cyclone hood-hood, so there
was earlier a cyclone is going to come a cyclone
is going to come.
So all this cyclones were never getting named
but nowadays all cyclones are named because
already World Metrological Organisation has
already finalised the names.
So just for a trivia, so if you see what are
the names from Northern Indian Ocean names,
so Bangladesh has contributed this, Bangladesh
has contributed Onil, Ogni, Nisha, Giri, India
has contributed Agni, Akash, Bijli, Jal, so
on and so forth Maldives has given Hibaru,
Gonu, Aila and Keila.
If you remember this Aila was also cyclone
Aila or typhoon Aila we couple of years back
we were hearing about this particular name.
So just to summarise with respect to the hurricane
index that the CHI value is always calculated
for a particular hurricane or particular cyclone
and CME when this contracts were available
for trading CME used to list these contracts
some time just before the this cyclone is
about to landfall maybe 6-7 days before the
cyclone is about to make a landfall and whatever
trading was happening, trading was happening
during this 6-7 days and the day the the hurricane
made a landfall on made a landfall that come
that day the exchange was coming to an end.
So the maturity period of the contract was
very short and it was not predefined, it could
be 4 days, 5 days or 6 days as long as the
hurricane makes a landfall.
Also there are lot of other weather derivatives
on OTC market river flow reservoir, label
index, sea temperature index, wind speed index,
so based on many parameters you had weather
derivatives contracts signed by companies
in the OTC market by companies and counter
parties.
So here this exchange traded weather derivatives
contracts have significant amount of basis
risk because geographical and location basis
risk is one of the very important risk, it
arises due to locational difference between
the reference site of weather derivative and
the actual production or activity area.
As I eh mentioned let us say this Nasik farmer
from sorry grape farmers from Nasik, let us
say temperature contract is available at for
Nasik region but let us say grape farmer from
Bangalore would like to enter into that temperature
contract, so in that case that that kind of
a, if Bangalore grape farmers enter into derivative
contracts, temperature related derivative
contracts which are based on Nasik’s temperature
than this will be an example of a geographical
or locational basis risk.
Also time and calendar basis risk, the duration
of the weather contract or the maturity period
of the weather weather contract may not be
coinciding with the actual requirement of
the company who is interested to buy or sell
those weather contracts.
So that is gives rise to your time and calendar
basis risk and also product basis risk, what
is a product basis risk?
Let us say a Bangalore farmer grape farmer
is interested not only to buy a contract on
weather, also he is interested to buy contract
on frost because frost also affects the grape
output significantly quality of grade out
grape output significantly.
So you may have so no exchange traded contract
will be able to combine the combine the risk
associated to with weather and the frost.
So the exchange or this company may have to
go for a temperature related contract and
a frost related contract if these are available,
of course in India as I mentioned none of
the weather related contracts are yet to make
their debut and however in this last 2 this
2 sessions I thought of discussing because
this is a very important part of mitigating
weather related risk.
So with this I will be ending this session
and let just to summarise weather contracts
are not weather derivative contracts are not
weather derivative contracts are not to mitigate
the catastrophic loss and popular weather
derivative contracts which are trading currently
at CME is your contracts pertaining to temperature
and you can have contracts on snowfall, rainfall,
frost or any weather parameter and at one
point of time hurricane related contracts
were traded and it was a very interesting
contract.
Of course most of this contracts are not trading
at CME because lack of participation by traders.
So with this I will be ending up this discussion
and thanking all of you, looking forward to
again meeting you all in the next session,
thank you, thank you all of you.
