Monsoon season has a direct impact on agricultural sector, which has an impact on industrial sector as well, particularly for FMCG companies which depends on agricultural and rural market. It also causes shortage of water supply for production of power and electricity. Electricity shortage has a strong effect on almost all sectors, which also causes delay in productions or increase in costing of products. Globalization of Indian economy has changed the landscape of Indian business by increasing the number of alternative products in the market. One among them is Derivatives’ market. Trading in derivatives has been recently introduced in India. Derivatives are so sensitive that if they are in correct hands, they are wonderful vehicles and if not, they are very dangerous. Hence before trading, it is very essential for the traders to know about derivatives and their market. Weather derivatives are financial instruments that can be used by organizations or individuals to reduce risk associated with adverse or unexpected weather conditions. The difference from other derivatives is that the underlying asset (rain/temperature/snow) has no direct value to price the weather derivative. Weather exerts a great influence on businesses such as producing energy and agriculture. Weather Derivative still has not been introduced in the Indian Market. With the recent amendments to the Securities Contract Regulation Act, derivatives trading are allowed in commodities. It was banned till last year. But trading in weather derivatives is yet to receive a formal nod from the government. The bank is selling weather derivatives as an over-the-counter product to companies whose operations are significantly dependent on weather conditions. ABN-Amro Bank is exploring sales of weather derivatives and catastrophe bonds for the first time in the country. The bank is talking to companies in the beverage and cement sectors, to airlines and oil majors to get them interested in the product. Types of Weather Derivatives Various brokerage and trading firms customize the weather derivatives to the client’sA needs. Only certain parties may be interested in trading a specific type of weatherA commodity based on their business structure. Some of the common weather derivativeA products include 1. Swaps Swaps are contracts where two parties agree to exchange their risks. This will produce aA more stable cash flow when weather conditions are volatile. In simple terms one partyA agrees to pay the other if the contracted index settles above a certain level while the otherA agrees to pay if the index settles below that level. Swaps have no premium but provide protection from adverse weather in return for givingA up some of the upside of a favourable season. A 2. Collars Collar is similar to swap in that protection against adverse weather is provided in returnA for giving up some of the returns generated in favourable conditions. The difference is thatA the payments to and from the parties’ takes place outside an upper and lower level. ThisA allows revenues to fluctuate within a normal range of weather conditions but protectsA either party against extreme weather. 3. Puts (Floors) Put options or floors are contracts that compensate a buyer if a weather variable fallsA below a predetermined level. This type of protection involves a premium being paidA upfront. It provides protection against adverse weather whilst allowing profits to beA retained in a favourable period. For instance, a ski resort may buy a Put on the level ofA snowfall over a skiing period. This would then compensate the resort if the level ofA snowfall is low deterring a large number of skiers. If the level of snowfall is high, theA resort loses only the premium paid. 4. Calls (Caps) Call option or Caps are contracts that compensate a buyer if a weather variable fallsA above a predetermined level. This type of protection also involves a premium being paidA upfront. It provides protection against adverse weather whilst allowing profits to beA retained in a favorable period. To illustrate, a commercial airfield might buy a call optionA when the number of days that the average wind speed exceeds a certain level. This would compensate the airfield for the loss of revenue during days when they had to stop flying. Two of the non-standard weather contracts, which are gaining popularity, are: Compounds is a structure that provides the buyer with the option to purchase or sell aA weather contract on an agreed date in the future. This future date must be prior to the startA date of the underlying weather contract. This requires a premium payment. If the buyerA exercises the compound at the later date, a second premium payment would be required.A It provides the buyer an option to cancel the purchase of the contract if he feels weather protection is not required.A Digital is a contract that has linear payouts. In other words it provides a fixed amount ofA payout if a particular weather event occurs. If the event does not occur there is no payout,A only the premium stands lost. How is it different from insurance? Insurance contracts cover high risk, low probability scenarios whereas weatherA derivatives cover low risk, high probability scenarios. With weather derivatives the payout is designed to be in proportion to theA magnitude of the phenomenon whereas insurance pays a one off lump sum whichA may or may not be proportional and hence lacks flexibility. A Insurance normally will payout if there has been damage or loss. WeatherA derivatives require only that the index has passed on a certain point. Weather derivatives are index-based securities, which allow many players toA participate in the market. This increases liquidity. It is possible to monitor the performance of the hedged weather derivatives duringA the life of the contract. Additional shorter term forecasting towards the end of theA contract might mean that one can remove himself from the weather derivative.A Because it is a traded security there will always be a price at which one can sell or buyback the contract. Indian Relevance In the Indian context weather futures would prove to be immensely beneficial, especiallyA to the agricultural sector, which is dependent on the vagaries of monsoon? This derivativeA product would be an effective alternative to the crop insurance product, the premium for this, at around 18%, is seen as costly by the farming community. ABN AMRO Bank is exploring the sale of weather derivatives for the first time in theA country. Currently the bank is in talks with the cement and beverage sector. Airlines andA oil majors of the country have also shown interest in these securities. ICICI Lombard hasA also come up with the sale of weather derivatives, its first client being Malana PowerA Company for coverage of Rs.10 crore. The cover puts a floor on the uncertainties in the event that adequate rainfall is not available. With a wide scope for weather derivatives in India, a number of trading firms are expected to offer customized weather derivative products and lot more industries are expected to be covered in this net. A farmer’s common complaint “Everybody talks aboutA the weather, but nobody does anything about it” will soon become a thing of the past withA weather. The knowledge of derivatives in itself is limited to certain segments of the society, leave alone the weather derivatives. In spite of the challenges, it is time the Government speeded up the process of launching weather derivatives in India too. Commodity trading The role of commodity futures markets becomes even more compelling with India moving toward greater trade liberalization, particularly in the context of agriculture, and getting further exposed to the volatilities of international trade and finance. Commodity futures is a market mechanism that is viable for risk management and price discovery, and such institutions can help “bail out” the economy from the vagaries of international trade. Despite the realization of the need for commodity derivative trading in India and the subsequent resumption of trade in the new millennium, the statutes dictating derivative trading are old and outmoded. Derivative markets have been functioning under the Forward Contracts Regulation Act (FCRA). An amendment to the FCRA will usher in a new era in commodity derivative trading by expanding the scope and instruments of trading, and by strengthening the regulatory powers of the FMC. Among the changes proposed in the Bill, an important intervention is to bring about a change in the definition of “commodities” to facilitate trading in derivative contracts for intangibles like commodity indices, weather derivatives, etc. In an agrarian economy like India, where Fifty per cent of irrigation is rain-fed and monsoons determine rural demand patterns, fertilizer off take, agricultural commodity prices, water utilities, energy consumption and construction costs, Weather derivatives can aptly be positioned as hedging instruments for farmers. These prospects in Weather risk management will also benefit the Utility and energy companies to protect their volume-related revenues against unnatural weather, Distributors of crude oil to make up for reduced business in the winter, Agricultural companies to minimise the uncertainty in revenue due to flood, freeze or drought and also Insurance companies to reduce their own exposure to weather-related claims.
In India, RaboBank and ABN Amro have been the first off the block to introduce weather derivatives help manage weather risk, which has now expanded to include end user industries such as beverage sales, agriculture, power generation, oil exploration, tourism, insurance , cold drink breweries, wind farms and sugar industries.
As a start (Jan 11, 2005), With all the necessary infrastructure to offer deliveries through dematerialized warehouse receipts by linking up with panchayats and anticipating a strong demand , NCDEX is in favour of launching this product. More demand can be generated by an amendment of the existing Securities Contract (Regulation) Act, where derivative trading is allowed in a commodity, which can be physically delivered. The phase I, whereby NCDEX will offer trading in futures of bullion and seven agri-products – soybean, Soya oil, mustard seed and its oil; crude palm oil, RBD palmolein and cotton, is expected to attract many counterparts who would be more than willing to absorb the risk
The institutional segment of the capital market has not yet begun to use derivatives for risk hedging or for position taking in the way that such investors should. First, the development of derivatives has so far been excessively skewed toward derivatives used in the equity rather than debtor forex markets. Second, One the one side India have foreign and privately owned (new generation) domestic banks who run a (interest rate) derivative trading book but do not have the ability to set significant counter party credit limits on a large segment of corporate customers of PSBs. On the other side, are PSBs who have the ability to set significant counter party credit limits, but are unable or unwilling to write IRS’ or FRAs with them.
Regulatory conservatism and failure are inhibiting the emergence of more types of derivatives – e.g. currency, interest-rate and credit derivatives as well as long-term tailored as well as traded swaps and swaptions. Without speculative counter-parties, financial markets would be illiquid, inefficient and ineffective in fulfilling their main purpose as resource mobilizing and allocating mechanisms. In financial markets it is speculators (or, in more neutral parlance, insurers, market-makers and options-writers) who enable efficient price-discovery in real-time and allow for efficient, continuous two-way, ‘bid-ask’ market-making.
Measure of Weather derivative A degree-day (DD) has emerged as a common measure of temperature, and measures the deviation of a day’s average temperature from the reference. An HDD occurs when the average temperature is below the reference, and a CDD when the average temperature is above. The CME contracts are based on an index that measures the extent and frequency that the average temperature drops below 65 degrees Fahrenheit (the reference) cumulated monthly across the relevant city. The futures contracts pay $100 per each point movement in the index. Earth Satellite Corporation, an independent entity, calculates the HDD index ensuring transparency and independence in the benchmark. Weather derivatives are financial products that enable an organisation to offset the financial risk due to a weather variable. They emerged as an offshoot of insurance. Insurance is expensive and requires a demonstration of loss (of assets or of profits). While well suited to calamities and extreme weather events such as earthquakes and typhoons, insurance does not work well with the uncertainties in normal weather. Consider insuring the loss in revenues for an umbrella manufacturer if the monsoons are a month late, or of the air-conditioner company if they are a month early. Weather derivatives could easily be adapted for use within India using rainfall, which is a more important variable in our context, as a benchmark. A rain day (RD), defined as a 24-hour period during which precipitation was in excess of the reference (20 mm), and an index cumulating the number of RDs between June 1 and September 30 can be used to compute pay-off. Not everybody’s exposure to monsoons is the same, and offsetting exposures of different entities will help in the emergence of a robust market. In the US, weather affects an estimated 20 per cent of the economy. In India, the figure would be higher. Fifty per cent of agriculture is based on rain-fed irrigation, and monsoons determine rural demand patterns. On a cursory glance, one can see that there are many industries besides agriculture that are directly impacted by rainfall. For example, fertiliser off take, agricultural commodity prices, water utilities, energy consumption, construction demand/costs, etc. The US weather market was driven primarily by energy producers and utilities, facing deregulation and competition and seeking to manage weather risks. However, its use is more generic–for protecting revenues when weather depresses demand or results in increased costs. And if the market is to develop or expand, there has to be demand from more diversified businesses like retail, manufacturing, and agriculture. Once end-users determine that weather too is a risk they would like to actively manage and hedge, there is unlikely to be a shortage of counterparts. Institutional investors looking for new asset classes not correlated with existing markets and banks offering integrated risk, the management would be more than willing to absorb the risk. The pricing of weather derivatives is, of course, another issue. One cannot buy or sell the underlying, be it sunshine or rain. Positions have to be hedged with offsetting positions and one cannot create a risk-free portfolio by combining the derivative with its underlying (as done for other derivatives). Though Caps, Collars and other exotics in weather are offered, the closed-form solution of classical Black-Scholes option theory has no application. Weather contracts are based more on forecasting than on mathematical derivation; it is the meteorologist who holds the sway and not the mathematician. Information on past weather behaviour and an understanding of the dynamics of the environment is essential. Predictability of even large-scale weather systems beyond a week is difficult at best. Even though it is a nascent market and has not as yet extended beyond the US, almost 2,000 “weather” swaps (private, off-exchange contracts between individual entities) with an estimated value of close to $3 billion have been negotiated. India needs to take some lead from events in other markets. Can we start with simple but overdue (equity) index trading?
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