Solutions

Getting a grip on climate risk

A new index lets investors express their views on how fast the planet is warming

cities – including New York, Chicago,

Atlanta, and Las Vegas – that are most
actively traded on the CME’s weather
derivatives exchange. Between May 2 and
September 3 this year, an excess temper-
ature of 0.68ºF on these contracts caused
the index to climb by almost 35%. This
performance showed minimal correlation
with any other investible asset class, a fact
that could make the climate an interesting
candidate for inclusion in otherwise tra-
ditional portfolios. Access to the index
would be via structured products, perhaps
in combination with other types of asset.
More cities could potentially be included
in the index. The CME currently trades
weather derivative contracts for 18 US and
nine European cities, as well as six Cana-
dian and two Japanese locations. To be
eligible for inclusion in the GWI, however,
the volume of futures traded for any given
city must represent 1% or more of the
total weather derivatives contracts traded
A broader swathe of investors can now give climate derivatives a whirl on the CME. Provided they meet this con-
dition, European and Asian cities are likely
to be included in the GWI over the me-
Weather derivatives have been traded Bank to come up with the world’s first dium term. A UBS-GWI governance com-
for the best part of a decade. In theory, ski index that tracks temperatures on a mittee will meet annually to determine
resorts could use them to hedge against national and regional rather than a local the composition and the weighting of the
warm winters or brewers to protect them- basis. Launched in April this year, the UBS UGWI index and its family of sub-indices,
selves against cool summers. In practice, Global Warming Index (UBS-GWI) is a trad- which currently covers four US regions: the
though, most users are in the energy sec- able benchmark for global investments in Northeast, Midwest, West and South.
tor. The Chicago Mercantile Exchange the weather derivatives market. It provides Although there has been a dramatic in-
(CME) established a weather derivatives a rational and simple way to obtain finan- crease in weather derivatives volumes over
exchange for temperature contracts ref- cial exposure to large-scale trends in the the course of the last few years, traded
erenced to certain US cities in September climate. The index should also prove useful products using weather remain inacces-
1999, later adding European and Asian to industries that need to hedge against sible to the vast majority of the financial
references. More recently, the CME has damaging climatic trends. Potential users community. Used mainly as a hedging in-
added contracts on snowfall, frost and could include many branches of agricul- strument by energy, insurance and com-
hurricanes. These innovations helped lift ture, tourism and construction. modity professionals, weather derivatives
total CME turnover in weather contracts remain largely untouched as an asset
to some $45 billion in 2005 –2006. This How it works class in their own right. UBS’s new Global
success has attracted attention elsewhere. The UBS-GWI is based on existing CME Warming Index could change that by pro-
In mid-2006, China’s Dalian Commodities weather futures contracts that settle on viding a simpler way for a broader range
Exchange announced that it planned to the difference between the average daily of institutional and private investors to
start trading weather futures, with the aim temperature and a base temperature of gain financial exposure to global tempera-
of helping Chinese farmers hedge their 65ºF. These are Heating Degree Day (HDD) ture trends.
exposure to bad weather. and Cooling Degree Day (CDD) contracts,
Weather, though, is not climate. As cli- so-called because they measure how far it
Ilija Murisic UBS Investment Bank,
matologists like to say, weather is what is necessary to heat or cool buildings in the Non-standard derivative products
you get while climate is what you expect. prevailing weather conditions. At present, ilija.murisic@ubs.com
This insight prompted UBS Investment the index comprises contracts on the 15 US

14 UBS News for Banks / Winter 2007