Since climate change and global warming have become an alarmingly debatable issue for the

world, a growing number of industries and companies are entering derivative markets to protect
their business from devastated consequences of weather variability (Pizzani, 2006). Undeniably,
buyers and sellers must critically consider the most appropriate derivative instrument to hedge
risks. So, this paper will briefly illustrate how both parties can use derivative instruments,
forwards, futures, swaps, and options, and finally evaluate which one is the best suitable
financial tool applied to hedge business’s risks associated with adverse weather conditions and
global warming.

Significantly, in a forward contract on weather, the underlying asset is a measure of the day’s
temperature, or the amount of disaster damage caused by unexpected climate changes (Chance,
2003). With this perspective, for instance, a farmer can prevent lower earnings or crop yields by
entering a forward weather index contract with an interested buyer. Technically, the farmer may
buy Heating Degree Days (HDD), or sell Cooling Degree Days (CDD), if he expects the weather
is too hot or too cool, too dry or too wet, during his harvesting period (Pizzani, 2006).

However, the farmer and the buyer could be exposed to a default risk even though the price is
locked, because the forward contract is individually customized, in other words, non-
standardized. So, a future contract would be a better solution for the both parties to avoid credit
risk, as it is traded in a standardized form provided by the exchange. Deposited account, initial
margin, margin call, and maintenance margin are accurately restricted by the exchange (Pizzani,
2006). So this would provide the long and the put with a high level of transparency and
assurance. Furthermore, besides the future contract on HDD and CDD for temperature hedge, the
farmer may consider a future contract on snowfall, precipitation, wind, humidity, hurricanes,
floods etc.

Nonetheless, a future contract initially charges for transaction cost, while a swap is a zero-cost
contract. Even though interest rate swaps and currency swaps are being commonly traded,
weather index swaps can be also applied (Chance, 2003). For example, two Japanese companies,
Tokyo Electric Power Company (TEPCO) and Tokyo Gas Supply Company (TGSC) agreed to
enter a swap contract on the average temperature of August and September of 2001. Under this

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private contract, TGSC could protect a decrease in revenue when the summer is too hot, while
TGSC also would stop losses if the summer turns to be too cool (KARIYA).

But here again, swaps are similar to forwards because they are both operated in an OTC or non-
standardized form. It seems to be lack of liquidity for swaps because of the difficulty in finding
interested partners to exchange. Hence, the most powerful hedger for weather related-risk is
options because of liquidy, reliably trasparent standardization, low cost, and high payoff . By
structuring European or American options, like futures, Chance (2003) stated that options are
exchange-traded and both parties face free-default risk. But, options permit buyers of caps and
floors to maximize payoff on expiration date, although low-price premiums are initially paid to
sellers. Another benefit is that premiums are not prepaid by buyers and both parties just post
margin, if they structure a future style option, according to Stern (2005). Thus, options are the
most effective tool for hedging weather-related risks.

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References

Chance, D. M. (2003). Analysis of derivatives for the CFA program. Virginia. AIMR. Chapter 2
Pages 25-37, Chapter 3 Pages 81-103, Chapter 4 Pages 159-194 and Chapter 5
Pages 269-285.

KARIYA, T. (n.d.). Weather Risk Swap Valuation.

Pizzani, L. (2006). Forecast for Weather Derivatives: This Hot Market Shows No Signs of
Cooling off. Financial Engineering News, September/October 2006.

Stern, H. (2005). "Evaluating the cost of protecting against global climate change: options
pricing theory and weather derivatives", 16th Conference on Climate
Variability and Change. San Diego, California, USA 9-13 Jan., 2005.

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