First, some background reading on weather derivatives:
This article from Canadian Investment Review is from back in 2002 so you can see that weather derivatives are really not that new as an asset class. The article was written by Jason Wei, a professor of finance at the University of Toronto. This is a powerpoint presentation from Wei and Melanie Cao of York University. It’s even older but gives some deeper understanding of how the weather derivatives markets evolved to that time, the types of instruments available and the basic strategies for use.
One of the big problems cited from that time was the lack of investor interest and the resulting issue of liquidity. With hedge funds actively participating in the weather derivative markets especially over the past few years (along with re-insurance/catastrophe bonds due to the spike in extreme hurricane activity), this is not as big an issue. The purpose of these documents is simply to give an idea of where this quite esoteric area of investing came from. I mean, if you tell your friends that your recently established investment is dependent on the heat in Baltimore, you won’t get that funny look?
Now, let’s focus on where we are today. Here’s the link to the Chicago Mercantile Exchange’s weather derivatives website. In the opening paragraph near the top, I found the last sentence quite interesting:
This sector of hedging and risk management products represents today’s fastest growing derivative market.
Fastest growing derivative market. Well, I suppose the other broad areas of equities, interest rates, currencies, commodities and real estate have built well established markets in this space so weather derivatives, despite being around since 1999 (at least on the Merc), are still the new kids on the block. But perhaps it’s also the added focus from the press on the global warming issue and personalities like Al Gore that have moved environmental finance forward as part of a broader solution to what is clearly a massive problem.
Once you arrive here to this site, you’ll see a list of weather contracts, many of them related to temperature but some that I think are quite interesting like the ones for frost and snowfall. Here in Toronto, we’ve been experiencing summer-like weather for the past week and a half. We have no spring or fall here, just a long winter and about four months of summer. I exaggerate but unless you live up here, you just won’t get it. The idea of profiting over the cold months sounds appealing. The idea of profiting from times of heavy snowfall can somewhat compensate any northerner’s aching back after shoveling their driveway. A snowblower would make sense but I’ve just discussed the massive environmental problem, right?
But, of course the reality is that there are many industries who rely on these derivative instruments for serious hedging needs. Think of a utility whose electricity usage spikes up during a heat wave. And, of course, there are the hedge funds on the other side willing to take their bet. Again, one of the popular areas in this field is in hurricane futures which is one of the instruments listed on the CME website. According to this section of the website:
The CME Weather Product group has added CME Hurricane futures and options on five U.S. defined areas - Gulf Coast, Florida, the Southern Atlantic Coast, the Northern Atlantic Coast and the Eastern U.S. The underlying indexes will be calculated by Carvill, a leading independent reinsurance intermediary in specialty reinsurance that tracks and calculates hurricane activity. These contracts will begin trading March 12, 2007 for the 2007 hurricane season that begins June 1.
You would think that this type of recent product development would be getting a lot of press, but I just don’t see it. Good for me and my little blog but if this was an ETF? Sheeesh! There’d be coverage left-right-and-center. Probably most of it would talk about how the industry was yet again finding another thin slice of the market to exploit with an ETF product offering.
But hey, weather is an attractively uncorrelated asset class and I’ve discussed at length and in too many occasions about the fact that this investing world is troubled by highly correlated asset classes leading to synchronized, and due to the multiple compounded herd mentality, sharp down markets.
There’s a lot on the CME website and from the previously cited CME Weather Products main page, the tabs for Education and Resources should provide more than enough background before you begin to implement. Just don’t think that you’re ahead of the curve by exploring of actually entering into this market. Take a look at this chart showing, no surprise, another market with recent explosive growth:
This global liquidity thing … it’s really something. If there’s a market for something out there that isn’t getting a ton of attention and money, it’s a rarity. Domestic automobiles and not much else, I think. This chart cites its source but I found it from this good article from Financial Engineering News. The article is interesting as it gives a nice story as to who is interested in these instruments and why.
For me, someone interested in the asset allocation problem, I’m interested in understanding how plugging something like a weather derivative will affect the overall performance of a globally diversified asset allocation program. As someone also interested in underlying beta risks in multi-strategy and fund-of-hedge fund mandates, I’m keen on knowing if these instruments are useful ingredients in a recipe to provide the appropriate short overlay to offset unwanted long market exposures.
Many different reasons to consider these new products. For many who are simply fascinated by the strength of recent hurricane seasons, perhaps a visit to the National Hurricane Center website might provide evidence to entice them into the new hurricane futures market. To each their own, but I can’t stress enough the need for uncorrelated investments and this area is one of the few that requires investor attention.