The use of derivative or financial derivative dates back to the industrial revolution, indeed the productivity of the global economy appears to largely driven by the availability of strong financial institutions that support, Agricultural sector, Manufacture industries, Energy sector. For many years, weather derivatives has been the world’s most important source of providing investment and also reduction of risk associated with financial and the business environment mostly in USA.
Weather derivative are specially designed market derivative or financial instruments use by organization, business institutions or individual who wants to manage the systemic risk associated with unexpected change in weather patterns.
The process or the assessment process involves the use of weather data to create index-based instruments for which payment of claims are based on. The process of formulating this kind of index-based instrument is to ensure benefit-cost trade-offs of risk reduction and deciding on the appropriate action or measures to ensure efficiency in financial market.
Contrary to the insurance-based cover, for indemnity or claims there is no need to demonstrate that a loss has been suffered, however an indemnity insurance policy for weather is a rarely utilized instrument.
Settlement is objective, based on the final value of the chosen weather index over the chosen period. Payments of claims are done in a short period normally in days and this is well structure in the contract.
The first ever weather derivative contract was introduce in July 1996 between Aquila Energy Ltd and Consolidated Edison Ltd. The transaction deal involve the purchase of electric energy from Aquila Energy Ltd for the month of August.
The price of the energy was agreed, and a special weather condition clause was embedded into the contract.
This clause stipulated that Aquila would pay Consolidated Edison a rebate if August turned out to be cooler than expected. The measurement of this was referenced to Cooling Degree Days measured at New York City’s Central Park weather station.
If total Cooling Degree Days were from 0 to 10% below the expected 320, the company received no discount to the power price, but if total Cooling Degree Days is between 11 to 20% below normal, Consolidate Edison Ltd would be given an amount of $16,000 as a discount. Other discounted levels were worked in for even greater departures from normal.
The second weather derivative market was entered by El Ni?o winter of 1997-98 business institution to sign the weather derivatives. Many business, are likelihood with the possibility of significant fall of profit because of risk of weather, deciding to hedge their seasonal weather risk is like win-win for the business.
Weather derivative contracts are particularly attractive to businesses that have experience with financial options and futures. The insurance firms was facing a cyclical period of low premiums in traditional underwriting businesses in this same period and was in a position to make available sufficient amounts of risk capital to hedge weather risk.
Agriculture is traditionally perceived as a highly weather sensitive sector of economy. Lazo et al. (2011) confirmed it to be the second most weather sensitive sector of the US economy, following mining, with 12.1% of output being exposed to weather.
Within the EU project “Weather Impacts on Natural, Social and Economic Systems – WISE”, the impact of weather on agriculture has been studied in the United Kingdom (Subak et al. 2000), Netherlands (Tol 2000), Germany (Flechsig et al. 2000) and Italy (Galeotti et al. 2004).
The great appeal of weather derivatives is that they can be used to hedge risks in other components of an investment portfolio. Many businesses are exposed to weather risk of some kind. The challenge in hedging is to cover these risks in an effective manner.
There is a great deal of discussion about using weather options to hedge weather risk in energy markets, for example. Some care is necessary in building a net position containing a physical commodity, such as gas or power, along with weather options. In this case, weather options are a hedge on volume, not on price.
Company has a number of options in structuring a weather deal. Ghana is crude oil importer and of the factors that affect the international price of crude oil is weather and natural disaster. Most of this natural disaster are cause by bad weather, this means that weather affect the way we do business in the world. The best way for Ghana to walk away from this problem is to hedge the price of crude within the months in which bad weather has effect on crude oil price.
The benefit of this is that, it keep inflation stable and the cost of domestic oil price also become stable. Because crude oil price increment affect the entry economy, since oil is input for the production of goods and service an increase in oil price, produce also pass on the additional increase to consumers. So employing the weather derivative help reduce the negative effect that comes without using it at all. This weather derivative can be done jointly by insurance and investment or equity firms where insurance company would do the underwriting.
With this a Utility providers (Gridco or Volta River Authority) with weather exposure may choose to buy or sell a futures contract, which is equivalent to a swap such that one counter party gets paid if the degree days over a specified period are greater than the strike level, and the other party gets paid if the degree days over that period are less than the strike. A business may also choose to write an option.
Weather affect the demand for, and supply of, farming input and output in the agribusiness. In Ghana the production of food crops like tomato’s is very high and the production yield are variability arises primarily from climate risk. The amount of tomato’s that got rotten very season is quite high and making available derivative policy will help reduce the rotten rate.
Again, introducing this type of market instrument into Ghana’s commodity market would help the farmers, since they use weather derivatives to hedge against post harvests caused by failing in weather condition during cultivation, excessive rain during harvesting, high winds in case of plantations or temperature variability’s in case of greenhouse crops contracts to smooth earnings. The losses of food crops and other product in our various market can also be hedge against. An excessive rain during the harvest can significantly impair the quality of coco, cotton, tobacco, vegetables, etc. (Skees 2002).
Growing crops is often affected by several meteorological elements that are mutually interrelated For example, the grapes cultivation is exposed to temperature, sunshine, humidity and rain (Gladstone 1992). Respective meteorological elements affect different crops at different stages of their growth cycle. Weather that favours the germination phase can harm the ripening stage, and vice versa.
Moreover, insufficient amounts of a certain meteorological elements adversely affect the quantity and quality of the yield of many crops, as well as the excessive amounts of the same meteorological element (Manfredo and Richards 2009, Zara 2010)
Climate change has shown that weather does not need to be extreme to have serious financial consequences on companies’ performance because even minor adverse weather deviations can cause negative impacts on companies’ cash flows and value.
High earnings volatility can decrease company’s credit ratings and result in higher rates of borrowing capital. In order to diminish negative effects of adverse weather and consequential earnings volatility in Ghana, companies need to employ effective weather risk management skill.
Weather derivatives present a new tool of non-catastrophic weather risk management, offering many advantages over alternative management tools. Potential application of weather derivatives by beverage retailers would be to cover highly weather sensitive month(s) in order to reimburse lost sales due to poor weather, with the indemnity paid by weather derivative.
The final aim is to achieve lower sales variability, i.e., lower uncertainty and risk. The impact of weather on business activities has been mainly studied in primary and secondary activities highly sensitive to weather such as agriculture, farming, and energy.
In the tertiary sector, the majority of studies were done in finance. Retail remains rather understudied in Ghana, even though many sales managers often blame weather for poor sales. The problem of weather sensitivity is gaining increasing awareness among retailers business in Ghana example Fanmilk Ghana Ltd. It is why weather sensitivity and weather risk management in retail forced itself as an understudied subject.
Weather derivative and Sport Event in GhanaA sports event managing company may wish to hedge the loss by entering into a weather derivative contract because if it rains the day of the sporting event, fewer tickets will be sold. Such an accumulation can be the basis for a derivative contract which might be structured as an option (call or put) or as a ‘swap’ that is an agreement to pay or to receive payment.
Weather derivatives provide a pure non-correlated alternative to traditional financial markets. An online weather derivative exchange Massive Rainfall was created in 2014 and has been used to betting game company or hedge on specific temperatures, wind speeds and rainfall for specific days in select cities, however it appears to be only an educational tool for practice accounts in a non- existent currency.
A major limitation to effective application of weather derivatives is basis risk arising from the fact that payoffs under derivatives are determined solely on the value of weather index regardless of the actual damage caused by adverse weather.
Basis risk arises from imperfect correlation between underlying weather index and resulting business performance (production related basis risk) and discrepancy between period (temporal basis risk) and location (geographical basis risk) covered by weather derivatives and those actually exposed to weather risk.
Business pricing requires the company utilizing weather derivative instruments to understand how its financial performance is affected by adverse weather conditions across a variety of outcomes (i.e. obtain a utility curve with respect to particular weather variables).
Then the user can determine how much he/she is willing to pay in order to protect his/her business from those conditions in case they occurred based on his/her cost-benefit analysis and appetite for risk. In this way, a business can obtain a “guaranteed weather” for the period in question, largely reducing the expenses/revenue variations due to weather.
Alternatively, an investor seeking a certain level of return for a certain level of risk can determine what price he is willing to pay for bearing particular outcome risk related to a particular weather instrument.
Defining an appropriate mean and standard deviation is the key challenge in simple-option pricing. The problem is that climate is non-stationary, which is to say that the relevant mean and standard deviation evolve with time. This problem is well known among climate researchers who have struggled to determine the Optimal Climate Normal or the optimal average time scale of previous years for determining the expected value for this year.
There are many challenges to the effective use and management of weather options, and we have detailed a few of them. Pricing models for weather derivatives exist at many levels of sophistication and the simple analytical model shown here is not necessarily what the market makers use. This said, a simple model can give a rough idea of what an option should cost.
Weather derivatives can be very useful to risk managers who understand options and the risk profile associated with buying and selling weather options relative to their business. It is fairly straightforward to add weather options to a Value At Risk (VAR) calculation. There is a range of interesting complications, however, in adding weather options to a portfolio that already contains risks correlated to climatological variability.
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