Russian Trading System

Stock Exchange

How to work with weather futures?

Using futures on the weather

•

Hedging economic activity from unfavourable temperature curves of the environment.

•

Speculative operations connected with the weather broadcast of a certain period.

•

As the indices on temperature curves are figures which don’t depend on any events, the derivatives on these instruments can be used for diversification of risks for a portfolio.

Potential participants of weather futures market

1.

2.

3.

4.

5.

6.

7.

8.

9.

Energy resource producers Energy resource consumers Manufacturers of heating and cooling equipment Manufacturers of warm clothes garments Manufacturers and sellers of automobile spares Tourist agencies Housing and communal services Beverage producers Insurance companies

Implementation of weather futures

1. Parties concerned: 2. Energy producers 3. Energy suppliers 4. Producers of heating and cooling equipment 5. Manufacturers of warm clothes garments 6. Tourist agencies 7. Housing and communal services 8. Beverage producers 9. Etc.

Futures on HDD/CDD indices

Basic asset Contract price Contract cost Type of execution Months of execution Last day of trading Date of execution Minimal initial margin

Index HDD/CDD Index value HDD/CDD Index value HDD/CDD x N RUR Cash settlement (initial margin transfer) Monthly Last day of delivery month Last day of delivery month xxx

HDD/CDD indices

HDD index contracts are for spells of cold weather

HDD – heating degree days Degree day – the difference between the average day temperature and the base one.

Subject to temperature being below the base level, the consumers will use more energy for heating, higher temperature will cause more consumption of energy for cooling.

HDD i

 max  0 ,

t ref



t i

 t t where HDD i ref – indicator for i-day; – base level of temperature; i – average temperature for i-day.

HDD/CDD indices

CDD index contracts are for spells of warm weather.

CDD – cooling degree days Degree day – the difference between the average day temperature and the base one.

Subject to temperature being below the base level, the consumers will use more energy for heating, higher temperature will cause more consumption of energy for cooling.

CDD i

 max 

t i



t ref

, 0  where CDD i – indicator for i-day; t t i ref – base level of temperature; – average temperature for i-day.

Example 1.

Hedging from high temperature in the winter Seller of black oil Is willing to hedge from the risks of sale decrease in the warm week of February Average statistical t= -20

°

C For this level HDD for the week = max (0;(18+20))*7=266 points A thaw has been broadcasted up to t= –14

°

C For an average temperature of –14

°

C HDD for the week = 224 points Subject to high temperature (above -20 decrease.

With temperature rise of 1

° °

C), the consumers will not be in need of extra heating and the amount of black oil consumption will C, daily loss of the black oil seller will amount to 1000 rub. or 7000 rub. For a week of thaw The goal is to keep the profit at the level of that of -20

°

C.

A futures contract is able to set the profit from the sales of black oil at the required level

Example 1.

Hedging from high temperature in the winter Solution: To sell a futures on HDD index for the warm week Temperature above -20 decrease

°

C (warmer): The futures allows the seller to get the profit, which covers the losses from the sales Temperature below -20

°

C (colder): The seller gets an extra profit from the black oil sales, whereas it’s the same as the sum of his loss with the futures contract

Date

Example 1.

Т av HDD Ave rage s tat future s ne t price

21.01.2006

22.01.2006

23.01.2006

24.01.2006

25.01.2006

26.01.2006

27.01.2006

28.01.2006

29.01.2006

30.01.2006

31.01.2006

01.02.2006

02.02.2006

03.02.2006

04.02.2006

05.02.2006

06.02.2006

07.02.2006

Average -23 -22 -22 -21 -20 -20 -20 -19 -18 -18 -17 -15 -20 -18 -10 -12 -14 -15 -14,8571 the moment of selling the futures 33 38 36 28 30 32 33 32,85714 266 266 266 266 266 266 266 price of execution 266 259 252 252 245 230 261 251 219 225 229 230 230

Example 1.

Temperature and price dynamics

270 260 250 240 230 220 210 200 27 .0

1.

20 06 Real futures price Т av 28 .0

1.

20 06 29 .0

1.

20 06 30 .0

1.

20 06 31 .0

1.

20 06 01 .0

2.

20 06 02 .0

2.

20 06 03 .0

2.

20 06 04 .0

2.

20 06 05 .0

2.

20 06 06 .0

2.

20 06 07 .0

2.

20 06 -21 -19 -17 -15 -9 -7 -5 -13 -11

Example 1.

Date

27.01.2006

Hedging from high temperature in the winter

Operation Selling the futures 100 at 266 points (1 point = 10 rubles) Financial settlements IM = 10%*2660=266 rubles IM for 100 futures 26600 rubles

08.02.2006

Execution of 100 futures at = 230 points Getting profit from futures and returning the IM

Profit from 100 futures = (266-230)*10 rub.*100 contracts = 36 000 rubles.

Temperature rise up to –14,8 could cause in (–20-(-14,8))*7*1000 = 36000 rubles loss.

Example 2.

Hedging from high temperature in the winter Using the index of average daily temperature: MI=100+DAT DAT – average monthly temperature

Solutions to find when developing a weather futures 1. Which index to use.

2. Which base temperature to use.

3. How to calculate the average day temperature.

4. For which cities to calculate the temperature.

5. For which period of time to collect the data of the temperature curves.

6. Whether the hedgers have research of the dependence of financial-economic activity.

Contact details: RTS Derivatives Department Tel/Fax: 007 495 705 90 31 E-mail: [email protected]

Web: www.rts.ru or www.forts.ru