Future Derivatives

A derivative is a security whose price is dependent upon or derived from one or more underlying assets. The derivative itself is merely a contract between two or more parties. Its value is determined by fluctuations in the underlying asset. The most common underlying assets include stocks, bonds, commodities, currencies, interest rates and market indexes. Most derivatives are characterized by high leverage. Futures contracts, forward contracts, options and swaps are the most common types of derivatives. A futures derivative contract is a standardized contract between two parties to buy or sell a specified asset of standardized quantity and quality for a price agreed upon today (the futures price or strike price) with delivery and payment occurring at a specified future date, the delivery date. The contracts are negotiated at a futures exchange, which acts as an intermediary between the two parties. The party agreeing to buy the underlying asset in the future, the "buyer" of the contract, is said to be "long", and the party agreeing to sell the asset in the future, the "seller" of the contract, is said to be "short". The terminology reflects the expectations of the partiesthe buyer hopes or expects that the asset price is going to increase, while the seller hopes or expects that it will decrease in near future. In many cases, the underlying asset to a futures contract may not be traditional commodities at all that is, for financial futures the underlying item can be any financial instrument (also including currency, bonds, and stocks); they can be also based on intangible assets or referenced items, such as stock indexes and interest rates. While the futures contract specifies a trade taking place in the future, the purpose of the futures exchange institution is to act as intermediary and minimize the risk of default by either party. Thus the exchange requires both parties to put up an initial amount of cash, the margin. Additionally, since the futures price will generally change daily, the difference in the prior agreed-upon price and the daily futures price is settled daily also (variation margin). The exchange will draw money out of one party's margin account and put it into the other's so that each party has the appropriate daily loss or profit. If the margin account goes below a certain value, then a margin call is made and the account owner must replenish the margin account. This process is known as marking to market. Thus on the delivery date, the amount exchanged is not the specified price on the contract but the spot value (since any gain or loss has already been previously settled by marking to market).

Weather derivatives

Weather derivatives are financial instruments that can be used by organizations or individuals as part of a risk management strategy 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. The first weather derivative deal was in July 1996 when Aquila Energy structured a dual-commodity hedge for Consolidated Edison Co.[1] The transaction involved ConEd's purchase of electric power from Aquila for the month of August. The price of the power was agreed to, but a weather clause was embedded into the contract. Weather derivatives slowly began trading over-the-counter in 1997. As the market for these products grew, the Chicago Mercantile Exchange introduced the first exchange-traded weather futures contracts (and corresponding options), in 1999. Weather Risks Natural gas company suers negative impact in mild winter Construction companies buy WD (rain period) Cloth retailers sell fewer clothes in hot summer Salmon shery suer losses by increase of sea temperatures Ice cream producers (cold summers) Disney World (rain period)

Valuation : There is no standard model for valuing weather derivatives similar to the Black Scholes formula for pricing European style equity option and similar derivatives. That is due to the fact that underlying asset of the weather derivative is non-tradeable which violates a number of key assumptions of the BS Model. Typically weather derivatives are priced in a number of ways: Business pricing Business pricing requires the company utilizing weather derivative instruments to understand how its financial performance is affected by adverse weather conditions across variety of outcomes (i.e. obtain a utility curve with respect to particular weather variables). Then the user can determine how much he 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 certain level or return for certain level of risk can determine what price he is willing to pay for bearing particular outcome risk related to a particular weather instrument. Historical pricing (Burn analysis) The historical payout of the derivative is computed to find the expectation. The method is very quick and simple, but does not produce reliable estimates and could be used only as a

rough guideline. It does not incorporate variety of statistical and physical features characteristic of the weather system. Index modelling This approach requires building a model of the underlying index, i.e. the one upon which the derivative value is determined (for example monthly/seasonal cummulative heating degree days). The simplest way to model the index is just to model the distribution of historical index outcomes. We can adopt parametric or non-parametric distributions. For monthly cooling and heating degree days assuming a normal distribution is usually warranted. The predictive power of such model is rather limited. A better result can be obtained by modelling the index generating process on a finer scale. In the case of temperature contracts a model of the daily average (or min and max) temperature time series can be built. The daily temperature (or rain, snow, wind, etc.) model can be built using common statistical time series models (i.e. ARMA or Fourier transform in the frequency domain) purely based only on the features displayed in the historical time series of the index. A more sophisticated approach is to incorporate some physical intuition/relationships into our statistical models based on spatial and temporal correlation between weather occurring in various parts of the ocean-atmosphere system around the world (for example we can incorporate the effects of El Nio on temperatures and rainfall). Physical models of the weather We can utilize the output of numerical weather prediction models based on physical equation describing relationships in the weather system. Their predictive power tends to be less or similar to purely statistical models beyond time horizons of 1015 days. Ensemble forecasts are especially appropriate for weather derivative pricing within the contract period of a monthly temperature derivative. However, individuals members of the ensemble need to be 'dressed' (for example with gaussian kernels estimated from historical performance) before a reasonable probabilistic forecast can be obtained. Mixture of statistical and physical models A superior approach for modelling daily or monthly weather variable time series is to combine statistical and physical weather models using time-horizon varying weight which are obtained after optimization of those based on historical out-of-sample evaluation of the combined model scheme performance