Dr Harvey Stern,

1

• Dr Harvey Stern,
• Climate Manager, Victoria
• and

Griffith University
Mr Glen Dixon, Associate Lecturer (Finance),
Brisbane
2
Australian Agricultural and Resource Economics
Society, Queensland Branch Brisbane (DPI),
Friday 27 September 2002
Pricing Weather Derivatives in the Australian
Agricultural Market
3
Introduction

• Evidence of the challenge faced by the
  meteorological community to become skilled in
  applying risk management products from financial
  markets is growing.
• An empirical approach to the pricing of
  weather derivatives is presented. The approach is
  illustrated with several examples with focus on
  Agriculture.

4
Outline of Presentation

• The increasing focus on weather risk.
• Weather in company reports.
• Mitigating weather risk.
• New developments.
• Quantifying uncertainty in forecasts.
• Ensemble forecasting.

5
Background

• Weather risk is one of the biggest uncertainties
  facing business.
• We get droughts, floods, fire, cyclones
  (hurricanes), snow ice.
• Nevertheless, economic adversity is not
  restricted to disaster conditions.
• A mild winter ruins a skiing season, dry weather
  reduces crop yields, rain shuts-down
  entertainment construction.

6
Weather Climate Forecasts

• Daily weather forecasts may be used to manage
  short-term risk (e.g. pouring concrete).
• Seasonal climate forecasts may be used to manage
  risk associated with long-term activities (e.g.
  sowing crops).
• Forecasts are based on a combination of solutions
  to the equations of physics, and some
  statistical techniques.
• With the focus upon managing risk, the forecasts
  are increasingly being couched in probabilistic
  terms.

7
First Weather Derivative in Australia

• It is the energy and power industry that has,
  so far, taken best advantage of the opportunities
  presented by weather derivatives.
• Indeed, the first weather derivative contract
  was a temperature-related power swap transacted
  in August 1996.

8
First Weather Derivative Payout in Australia (1)

• Two temperature-based options contracts, which
  are claimed as Australias first weather
  derivatives deals, expired at the end of March
  1998 with a pay-out for the purchasing party.
• US Electric Utility Utilicorp sold the options to
  United Energy Marketing in late January, with a
  profit for United if during February and March
  temperatures hit
• 35 deg C or above on 5 days or more in
  Melbourne, Victoria or 33 deg C or above on 3
  days or more in Sydney, News South Wales.
• Source Energy and Power Risk Management
  June, 1998

9
First Weather Derivative Payout in Australia (2)

• By the end of March, temperatures had hit the
  required level on 5 different days in Sydney, and
  6 days in Melbourne, triggering payouts.
• Alan Rattray, VP of International Risk Management
  of Utilicorp Australia said the Sydney contract
  returned eight times the premium paid.
• Source Energy and Power Risk Management
  June, 1998

10
Weather Derivatives Defined

• Clewlow et al...(2000) describe weather
  derivatives as being similar "to conventional
  financial derivatives, the basic difference
  coming from the underlying variables that
  determine the pay-offs", such as temperature,
  precipitation, wind, heating degree days, and
  cooling degree days.

11
Weather Derivatives

• Weather derivatives are similar to conventional
  financial derivatives.
• The basic difference lies in the underlying
  variables that determine the pay-offs.
• These underlying variables include temperature,
  precipitation, wind, and heating ( cooling)
  degree days as described by Clewlow and
  Strickland.

12
Pricing Methodologies

• Historical simulation (look at examples using
  this technique).
• Direct modeling of the underlying variables
  distribution.
• Indirect modeling of the underlying variables
  distribution (via a Monte Carlo technique as this
  involves simulating a sequence of data).