First let’s start with some terms. since Wall Street had a rather difficult time in 2008 to the present let’s focus on the word derivative and what it means. What is a derivative? I mean really?
Weather Risk Management is now part of the insurance (reinsurance) and commodities industries. READ THIS SHORT PDF on Weather Risk Management commoditization.
Page 7 of this ReInsurance Brochure published by MET in the UK in 2009 clearly indicates the market’s goal of being able to forecast, predict and tip-off market makers in the weather derivatives, CAT bond and reinsurance schemes.
Also please read this recent press release (Strong Demand Seen for Weather Risk Management Contracts) to understand the financial size of this new industry.
PRESS RELEASE SOURCE: “As the weather risk industry approaches its decade mark, WRMA is pleased to see the market validating the usefulness of weather risk tools,” says Gearoid Lane, WRMA’s President. “Weather risk management works well both in times of major weather events and in times of normal weather. The 2007 Annual Survey results show clearly that the weather risk industry is here to stay.”
Reflecting a shift from seasonal to monthly contacts on the CME, the value of contracts traded during 2007 dropped to $19.2 billion. While that figure is down from 2006’s record of $45.2 billion, the 2007 figure is substantially higher than other years. For instance, in 2005 the total value of contracts was $8.4 billion. In 2004, the nominal value of contracts was $4.6 billion.
Looking at contract types, the value of temperature-related contracts on both CME futures and OTC markets was $18.9 billion. Nominal values for rain and wind were steady at $142 million and $36 million, respectively. Meanwhile, traders of OTC contracts representing ‘other’ contracts, such as weather contingent commodities, doubled to $65.8 million compared to 2006’s level of $34.7 million.
“The weather risk market no longer is a novelty to industries around the world. Agriculture, construction, banking, energy, insurance and other sectors see the real value in participating in the weather risk market,” Brian O’Hearne, Past President of WRMA and Managing Director of Swiss Re’s Environmental and Commodity Markets. “Weather risk tools are becoming essential to the bottom line of companies around the globe.”
Investors are Investing “Against” or “For” Black Swan Events … I Mean Catastrophes – Walker.
Derivatives in General.
A derivative is an agreement or contract that is not based on a real, or true, exchange, i.e.: There is nothing tangible like money, or a product, that is being exchanged. For example, a person goes to the grocery store, exchanges a currency (money) for a commodity (say, an apple). The exchange is complete, both parties have something tangible. If the purchaser had called the store and asked for the apple to be held for one hour while the purchaser drives to the store, and the seller agrees, then a derivative has been created. The agreement (derivative) is derived from a proposed exchange (trade money for apple in one hour, not now).
In financial terms, a derivative is a financial instrument – or more simply, an agreement between two people or two parties – that has a value determined by the price of something else (called the underlying). It is a financial contract with a value linked to the expected future price movements of the asset it is linked to – such as a share or a currency. There are many kinds of derivatives, with the most notable being swaps, futures, and options. However, since a derivative can be placed on any sort of security, the scope of all derivatives possible is near endless. Thus, the real definition of a derivative is an agreement between two parties that is contingent on a future outcome of the underlying.
Referring to derivatives as assets would be a misconception, since a derivative is incapable of having value of its own. However, some more commonplace derivatives, such as swaps, futures, and options, which have a theoretical face value that can be calculated using formulas, such as Black-Scholes, are frequently traded on open markets before their expiration date as if they were assets.
Derivatives are used by investors to
- provide leverage or gearing, such that a small movement in the underlying value can cause a large difference in the value of the derivative
- speculate and to make a profit if the value of the underlying asset moves the way they expect (e.g., moves in a given direction, stays in or out of a specified range, reaches a certain level)
- hedge or mitigate risk in the underlying, by entering into a derivative contract whose value moves in the opposite direction to their underlying position and cancels part or all of it out
- obtain exposure to underlying where it is not possible to trade in the underlying (e.g., weather derivatives)
- create optionability where the value of the derivative is linked to a specific condition or event (e.g., the underlying reaching a specific price level)
How might it work with weather? Weather Derivatives …
The following information is provided in jpeg picture file format because of its volatile nature. – Walker. At least so it would SEEM…