KWAME NKRUMAH UNIVERSITY OF SCIENCE AND

TECHNOLOGY

INSTITUTE OF DISTANCE LEARNING

FINANCIAL DERIVATIVES AND RISK MANAGEMENT

COURSE CODE: 675

LECTURER DR. DANIEL DOMEHER

GROUP ASSIGNMENT 2

MSC. ACCOUNTING AND FINANCE

ATTENDANCE

NAME STUDENT ID INDEX NUMBER

2 EDWARD ABANAH 20721857 PG4618620

3 BIO NATHANIEL 20762499 PG4637420

WEATHER DERIVATIVE
Weather derivative is defined as a legal contract between two individuals who indicate how
payment is going to be exchanged between them on the basis of a certain underlying weather
condition within the contract period.

It is very important to get the distinction between weather insurance and weather derivatives.
Insurance in general covers one-time risk and any payout that may or may not be proportional
to the risk. Weather derivatives are meant to expiate individuals proportionally once the
weather conditions meet the circumstances outlined in the contract. Purchasing a weather
derivative means initiating a monetary "balancing act" which uses higher revenues generated
in good times to offset lower returns in bad moments. (Barrieu, and Dischel 2002).

Insurance corporations intervened directly and indirectly in the weather risk market for quite a
long time, as they indemnify insurers of commercial or domestic properties that are likely to
face weather risks. They underwrite losses to be suffered from weather conditions like
windstorms, droughts, flooding, freezes etc. The exposures to these weather condition arise in
consequence of the normal business activities of insurers and are not regarded to be a
particular focus or specialty. Weather derivatives should not be mistaken as a replacement of
insurance contracts, as there exist vast differences as follow:

• Insurance contracts deal with high risk but low likelihood events whilst weather derivative
deals with low risk but high likelihood eventualities.

• For weather derivatives, the payouts are formulated to be proportional to the magnitude of
the phenomena. However, weather insurance contract pays a one-time lump sum that might
not necessary be proportional to the magnitude of the phenomena. It lacks flexibility.

• Weather insurance are comparatively expensive and requires a proof of loss. But weather
derivatives are relatively cheaper as compared to Insurance, they do not require any proof of
loss, and also, they provide protection against the uncertainty of variable weather condition.

Weather derivatives are generally differentiated from other commonly known derivatives. The
clear distinction is that, there is no underlying traded instrument on which weather derivatives
are based. Just like how bonds, foreign exchange, equity derivatives as examples, served as
traded instruments in the spot market, weather is not traded as an underlying instrument in the
same spot market.

This suggests that weather derivatives unlike the other types of derivatives, are not used as
hedgers against volatile prices of underlying instruments. Weather derivatives are rather used
as proxies to hedge against different weather-related risks, such as agricultural yield risk. The
idea behind weather hedging is simply to protect businesses against huge cost or fall in market
supply as a result of unfavorable weather conditions. Weather derivatives are essentially a
version of the traditional risk management tools. Weather derivatives are also used based on
the principles and mechanism of forwards, futures, options, swaps and combinations like
strangles, collars and straddles (Zeng and Perry, 2002).

An ideal weather derivative contract can be entered into by indicating the following
parameters below (Zeng, 2000):

 The type of contract

Also, there are four main forms of product that can be used in weather irisk-management
market. These are puts, calls, collar and swaps.

A call contract involves a seller and a buyer who have to agree first on a weather index and a
contract period that forms the basis of the contract. At the start of the contract, the buyer pays
a lump-sumi premium to the seller. In return, within the contract period or at the expiration
date of the contract, If (W) is greater than the pre-negotiated threshold (Si), the seller then
pays an amount to the buyer that is equal to:

P = k(W – S) …………………………………(equation.1)

The pre-agreed constant factor that determines the amount of payment per unit of weather
index is k (tick). When the weather index (W) is greater than the pre-negotiated threshold (S),
a fixed amount Po is paid. The difference between W and S determine the pay-off in the
contract, hence the contract cannot specify the pay-off.
Also, in a Put contract, the buyer receives payment from the seller when the weather index
(W) is less than the pre-negotiated threshold (S). Here, the premium size is the maximum
payable amount when W ≤ S. Market forces like demand and supply, maturity period and
price volatility determine the size of the premium.

In another breathe, Swaps under weather derivatives are contracts between two parties who
have agreed to exchange their risk. Under swap contracts, no party pays a premium. Payments
are made in a situations where the amount of P = k(W – S). Swaps come to play where there
is a given situation in which a Call is sold to Bi by Ai and a Puti is soldi to Ai by Bi. Thei
strikes are always determined in such a way that Calli and Put command the same premium.

HISTORY OF WEATHER DERIVATIVES AND HOW THEY ARE UTILISED

Weather derivatives evolve in the in 1997, as results of the terrible weather events of El Nino.
The events of El Nino which spine between the periods of 1996 – 1998 were considered as the
first major climate events forecasted accurately by the metrological community. The
forecasted El Nino winter in 1997 – 1998 was considered unseasonably mild. As a result, it
caused many companies that have their revenues tied to weather conditions came to the
realization of hedging against weather risk. During the period, insurance companies were also
capable of making available significant amount of capital to hedge against weather risk.
Several options with payouts tied to weather conditions were underwritten by the insurance
industry, which resulted in an increased liquidity for the development of several periodic
markets for weather derivatives. These events by the insurance industry made the derivative
market grew rapidly into an over-the-counter market (Considine, 2006).

The first exchanged-traded temperature-related weather future was introduced by the Chicago
Mercantile Exchange (CME) on 22nd September, 1999. This exchanged market came into the
scene to remove the counter-party credit risk resulting from the over-the-counter trading.
Investors of all kinds, both Large and small were given the opportunity to hedge against their
risks relating to weather, using liquid and contracts that are standardized, with an extra benefit
of getting access to best available prices at all given periods. The presence of a Clearing
House is one great advantage of the CME’s exchange-traded contracts, which helps to reduce
default risks associated with the over-the-counter trades. The clearing house serves as agent
linking both the seller and the buy in a weather future or option contract. This ensures that
both parties honor their respective obligations under the contract.

Temperature is the most commonly used weather derivative. Other forms are Options or
futures contracts that are linked to heating degree day (HDD) and cooling degree day (CDD)
indices, with payouts linked to the weather index. The ideal temperature to be considered in
cases where no cooling or heating is required is always 18o C with 30 days period spine.

A CASE FOR WEATHER DERIVATIVE IN GHANA

The weather system in Ghana can be considered in two seasons. These include:

- The dry season, it mostly spine from November to March, with an average
temperature range of 24o C to 31o C
- The wet season, this season is mostly experience in Ghana between the period of April
to October, with an average temperature range between 22o C to 31o C

There are several sectors that can benefit from trading in weather risk hedging in Ghana.

Agriculture is one great sector in Ghana that can benefit most from weather derivatives.
Weather conditions are major risk source in agriculture. This spine from the fact that, weather
conditions like rainfall, sunshine hours, temperature and wind greatly affect the quantity and
quality of a agricultural produce. There is a complex relationship between crop yield and
weather. A simple example is that, water-dependent crops like maize, yam, cassava etc can be
affected badly by drought. In the same vein, floods caused by too much rainfall which can
equally restrict oxygen supply needed by plant roots, there by leading to higher cases of crops
or plants disease.

There are three main risks faced by agricultural farmers (Parihar, 2003). These include:

- Price risk: this occurs when there is the likelihood of an adverse volatility in the price
of an agricultural produce. Prices of Agricultural produce are determined in Ghana by
the forces of supply and demand. Price of most agricultural produce do not mostly
favor farmers in Ghana and to curb this risk, farmers would have to enter into
forwards, future, and option contracts to hedge against adverse price volatility of their
produce.
 - Event risk: this comes to play when there is the probability of a catastrophic event
occurring, which will negatively affect yields from agriculture. Event risks are high in
nature with a low likelihood of occurring. This can include, dry season, fire outbreak,
floods etc.
- Yield risk: this point to the likelihood of farmers harvesting less than their normal
yields (output) in a particular season based on their inputs. With yield risk, the
probability of its occurrence is high but with an associated low risk. One factor that
contribute to this risk is the volume of rainfall and the timing of rainfall.

A POSSIBLE RAINFALL OPTION IN GHANA

In Ghana, forwards and futures contracts in agriculture can provide farmers with relatively a
straightforward instrument to hedge against price risk of their produce. The only difficulty to
manage however, is the quantity of the agricultural produce that would be sold. The quantity
produced and sold is in this case is dependent on weather conditions at a particular time.
Farmer who cultivates maize in the wet season for example will heavily be dependent on the
timing of rains and volume of rains received.

In this case, the historical rainfall data recorded by the weather station of the Ghana
meteorological agency for a particular area, would be used as a base for the strike quantity (S)
of the rainfall option. The strike point of the option would then be based on the index, which
is the amount of rainfall measured in millimeters for specific period. To make things practical,
if the average rains recorded for April, May and June at a specific area in Ghana was 250mm,
a three-month call option for these periods would have a strike point that is approximate to
250mm. In this case the actual rainfall over the same period would be the “actual quantity”
and this will determine the payouts of the option. In doing so, a predetermined cedi value per
every millimeter in excess or less than the strike point would determine the total payouts of
the option. An equally important features of the rainfall option to be considered are the
volatility (ɞ) of rainfall and the time (T) of every option contract.
 CONCLUSION

It is reliably clear that weather events serving as source of risk to agricultural produce can be
hedged against using weather derivative by farmers. Introducing weather derivative in Ghana
to hedge against price, yield and event risks that affect the agriculture market would be of
importance to farmers. Using rain option strategy and future contracts in agriculture would
permit farmers to concentrate more on their real farming activities simply because the major
risk types like price, yield and event faced by them would have been hedged against.

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