Course outline

Financial Time Series Analysis

•  1. Data analysis, probability, correlations, visualisation techniques
•  2. Time series analysis, random walk, autoregression, moving average
Patrick McSharry •  3. Technical analysis, trend following, mean reversion
patrick@mcsharry.net
www.mcsharry.net •  4. Nonlinear time series analysis
•  5. Nonlinear modelling, regime switching, neural networks
•  6. Parameter estimation, model selection, forecast evaluation
Trinity Term 2010
•  7. Volatility forecasting, GARCH, leverage effect
Dartington House Seminar Room 1
Mathematical Institute
•  8. Risk analysis, value at risk, quantile regression
University of Oxford •  9. Energy consumption, demand forecasting
•  10. Ensemble prediction, wind power generation
•  11. Weather derivatives, index-based insurance
•  12. Quantitative trading strategies, algorithmic trading

Lecture 11 Copyright © 2010 Patrick McSharry

Overview Carbon emissions

•  Historical weather observations
•  Future projections
•  Weather indices
•  Weather derivatives
•  Index-based insurance

Source: www.globalwarmingart.com

Reconstructed temperature Global warming

Source: www.globalwarmingart.com Source: www.globalwarmingart.com

1
 British rainfall extremes

•  British Rainfall (Symons, G. J.,1885) lists all observed 24 hour rainfall

depths which exceeded 2.5 inches (63.5mm). See Rodda et al. (2008)
Source: Wikipedia

Change in
Extreme rainfall trend
mean annual
temperature
by the end of
this century

Source: Little et al. (2008) Source: http://peseta.jrc.ec.europa.eu/

Change in Weather risk

mean annual
precipitation •  Fluctuations in the weather affect the revenues of
many sectors (agriculture, energy, retail,
by the end of transportation and construction)
this century •  Weather risk tends to influence demand rather
than price and adjustments of the latter are rarely
adequate to compensate for lost revenues
•  Insurance offers cover for low-probability extreme
events but it does not provide compensation for
the reduced demand that may result from slight
variations in the weather such as the temperature
Source: http://peseta.jrc.ec.europa.eu being warmer or colder than expected.

2
 Electricity load and temperature
•  Pardo et al. (2002) analysed the dependence of
electricity load on a population weighted
temperature index in Spain
Summer and winter regimes
•  The nonlinearity in the response function
prompted a separation of the effect into
summer and winter regimes
•  Typically 18oC (or 65 oF) is used as a
threshold variable to switch between
summer and winter regimes
•  Within each regime, the response is
approximately linear which facilitates
traditional linear time series analysis
Weather derivatives
•  Weather derivatives are financial instruments that
can form a risk management strategy to mitigate
risk associated with adverse or unexpected
weather conditions
•  Unlike other derivatives the underlying asset
(temperature, rainfall, wind, frost or snow) has no
direct value
•  Weather derivatives, in contrast to insurance,
provide protection against low-risk high-probability
events by treating the weather as a tradable
commodity, similar to a stock price or interest rate
www.cme.com/trading/prd/weather/
Electricity and temperature
•  Electricity demand displays a non-linear
U-shaped dependence on temperature
•  Demand increases both for decreasing and
increasing temperatures
•  This results from the use of electric heating
appliances in winter and air conditioners in
summer
•  There is a minimum around 18oC where the
demand is inelastic to temperature changes
Heating and cooling degree-days
•  Heating degree-day (HDD) and cooling degree-
day (CDD) are indices designed to reflect the
demand for energy needed to heat or cool:
•  HDD measures the intensity and duration of cold
in the winter
•  CDD measures the intensity and duration of heat
in the summer
Weather and revenues
•  By creating a weather index that can be linked to the
revenues of a particular organisation, it is then possible
to trade the weather in order to mitigate the risk of
adverse weather conditions
•  Advantages of decreased earnings volatility are efficient
use of equity, improving the company value to
stakeholders and availability of lower debt costs and
higher advance rates
•  The Chicago Mercantile Exchange (CME) introduced
exchange-traded weather derivatives in 1999 and now
provides standardised contracts for 18 US, nine
European, six Canadian and two Japanese cities
3
 Derivative pricing
•  Approaches employed for pricing weather
derivatives vary greatly, reflecting different
assumptions made about the variability of future
weather conditions over the duration of the
contract
•  The disparity results from the availability of a
range of atmospheric and statistical models
•  Further complications arise from the inclusion of
the effect of El Niño in the model.
Restaurant case study
•  In May 2002, Element Re announced a new
weather derivative transaction with The Rock
Garden, a London restaurant.
•  The contract was designed to protect the
restaurant against financial loss from colder-
than-normal weather from March 1-June 30.
•  The contract will pay out if the maximum daily
temperature is less than a pre-agreed level for
that month for more than a specified number of
days (8.5oC in March; 11oC in April; 14.5oC in
May; 18oC in June).
Weather Risk Management
•  A survey carried out for the Weather Risk Management
Association by PricewaterhouseCoopers in 2006
concluded that:
•  The total value of trades in the 2005/6 survey reached
$45.2 billion, compared to $9.7 billion in the 2004/5
survey
•  The CME experienced significant increases in both the
number of trades (increasing by a factor of 4) and the
value of those trades (increasing by a factor of 8)
•  HDD remains most common type of trade
www.wrma.org
Energy utility case study
•  If an energy utility believes that November may
be hotter than usual, possibly leading to reduced
revenues, it could take out a HDD swap
•  Suppose the reference was 18oC and the actual
average temperature on each day was 16oC, the
utility would receive 60 (30 x 2) times the agreed
sum of money for each degree-day
•  Alternatively if the average temperature on each
day was 19oC, the utility would have to pay 30
(30 x 1) the agreed sum of money for each
degree-day
Agriculture
•  Farmers are exposed to financial risk arising from
the variability in crop yield that occurs due to
different weather conditions.
•  Crop yield and price are weather-dependent. In
the case of corn, both temperature and
precipitation provide significant explanatory
variables.
•  Drought in particular presents a substantial risk.
Many farmers depend upon pre-financing against
their future revenue streams for seed, fertilizer, and
other agro chemical products.
Global warming
index
•  In April 2007, UBS launched a Global Warming index
(UBS-GWI) allowing businesses most affected by the
uncertainty of climate change to hedge their profits
against it in a simple and transparent fashion
•  The index is based on weather derivative contracts for
winter and summer traded on the Chicago Mercantile
Exchange (CME)
•  The index is currently based on 15 US cities, including
New York, Chicago, Atlanta and Las Vegas
•  If you think Mr Gore is an alarmist sensationalist, you
would sell the Index.
www.ubs.com/globalwarming
4
 Appetite for weather derivatives
•  “I think it’s a perfect market. You can’t spook it, you can’t
manipulate it. You can’t make people think it’s going to
be 110 degrees in London next week,” he says. “And of
course, weather is absolutely uncorrelated [to other
asset classes].” - Peter Brewer, Cumulus Weather Fund
•  No contract is too small. We’ve sold a weather derivative
contract for a dollar” - David Friedberg, Weatherbill
•  Weatherbill’s clients include car wash companies, hair
salons and golf courses. “The other day one farmer rang
me up and said his sows wouldn’t make a move to mate
if the temperature went above 95 degrees Fahrenheit.
He wanted to hedge against that.”
Source: FT, 20 June, 2007
Implementing IBI
•  Index-based insurance can be effectively delivered
through a wide range of products.
•  Government or international aid agencies can purchase
famine insurance based on a weather index tied to the
likelihood of droughts.
•  Individual producers can purchase insurance privately
from insurance providers, local banks, NGOs or some
partnership of these.
•  Insurance clauses can be folded into loan agreements
whereby indexes triggered by adverse events relax the
terms of the loan or pay it off.
How IBI works
•  Crop- and area-specific estimates are
aggregated and mapped to income via price
estimates, and then converted into a livelihood
loss index.
•  If weather data gathered throughout the contract
period indicates that rainfall was significantly
below historic averages the insurer pays out.
•  No moral hazard, no complication of counting
dead cows.
Index-based insurance (IBI)
•  IBI is an innovative means of managing weather risk by
assessing risk in terms of expected loss of income by
affected people whose livelihoods depend on agriculture/
farming that is highly susceptible to weather.
•  Traditional insurance products are based on an
individual's circumstances and losses.
•  In developing countries or remote rural areas, traditional
insurance services may not be available because of high
administration costs.
•  IBI is a more appropriate as it is based on a fixed trigger
mechanism not directly related to any individual farm.
This could be calculated on average crop yields, area
average livestock mortality rates, cumulative rainfall or
even data from satellite imagery.
Advantages of IBI
•  Where traditional insurance products
aren't available (too costly or impractical)
•  Where moral hazard is high
•  A means of reducing risk exposure for
vulnerable agricultural producers, giving
them confidence to invest in inputs and
strategies that will potentially give them
higher returns in other years.
Livestock insurance in
Mongolia
•  In Mongolia, livestock husbandry accounts for 87% of agricultural
GDP and supports at least half the population.
•  The country is prone to extreme climatic events that can cause high
rates of livestock mortality.
•  The insurance sector is immature and under capitalised.
•  Livestock insurance is a key element of risk mitigation but the
conventional approach, based on individual herder losses, has been
ineffective in Mongolian conditions. It has proved unpopular with
both insurers and herders with a high cost of verification and moral
hazard.
•  The government has now introduced an indexed mortality product
which embraces risks exposure of the herders
•  Risks are covered by the private insurance sector in Mongolia
•  A disaster recovery program is to be provided by Government
(maybe in years ahead by international reinsurers).
5
 Drought protection in
IBI challenges
Ethiopia
•  Lack of accurate climate models in
•  In 2006 the Ethiopian Government, in partnership with developing countries
the World food Program insured its farmers against
rainfall failure. •  Limited availability of reliable and objective
•  In return for a premium of US$930,000, the insurance data.
company would have paid out anything up to $7.1 million
in the case of severe drought.
•  Lack of weather stations in remote areas.
•  This money would have been given to the Ethiopian
Government on the condition that it would be used for •  Models that make index-based insurance
emergency relief and recovery.
contracts attractive to both buyers and
•  This means that the World food Program can rely on the
insurance money to pay for their relief work if there is a sellers.
climatic emergency, rather than having to depend on
donations, which can entail long delays.