Weather in company reports

1
Weather in company reports

• "Shares in Harvey Norman fell almost 4 per
  cent yesterday as a cool summer and a warm start
  to winter cut into sales growth at the furniture
  and electrical retailer's outlets Investors
  were expecting better and marked the shares down
  3.8 per cent to a low of 3.55
• Sales at Harvey Norman were hit on two
  fronts. Firstly, air conditioning sales were
  weak because the cool summer, and a warmer than
  usual start to winter had dampened demand for
  heating appliances.
• Source The Australian of 18 April, 2002

2
Agricultural Risk

• The Australian sugar industry is facing its
  fifth difficult year in a row with a drought
  dashing hopes of an improved crop in Queensland,
  where 95 of Australia's sugar is grown...
• Whilst dry weather during the May-December
  harvest period is ideal for cane, wet weather
  during this time causes the mature cane to
  produce more shoots and leaves, reducing its
  overall sugar content.
• Source Australian Financial Review of 8 May, 2002

3
Wheat Yields El Nino

• A Positive SOI (Wet/Rain) over Eastern Australia
• A Negative SOI (Drought/No Rain) over Eastern
  Australia

• SOI - Difference between the Darwin and Tahiti
  Pressure Across the Pacific - El-Nino

4
Should Companies Worry?

• In the good years, companies make big profits.
• In the bad years, companies make losses.
• - Doesnt it all balance out?
• - No. it doesnt.
• Companies whose earnings fluctuate wildly receive
  unsympathetic hearings from banks and potential
  investors.

5
Weather-linked Securities

• Weather-linked securities have prices which are
  linked to the historical weather in a region.
• They provide returns related to weather observed
  in the region subsequent to their purchase.
• They therefore may be used to help firms hedge
  against weather related risk.
• They also may be used to help speculators
  monetise their view of likely weather patterns.

6
An Early Example

• In 1992, Dr Harvey Stern explored a methodology
  to assess the risk of climate change.
• Option pricing theory was used to value
  instruments that might apply to temperature
  fluctuations and long-term trends.
• The methodology provided a tool to cost the risk
  faced (both risk on a global scale, and risk on a
  company specific scale).
• Such securities could be used to help firms hedge
  against risk related to climate change.

7
Cooling Degree Days (1855-2000)

• The chart shows frequency distribution of annual
  (yearly) Cooling Degree Days at Melbourne using
  all data

Each daily CDD is added up to find the annual CDDs
8
Cooling Degree Days (1971-2000)

• The chart shows frequency distribution of annual
  Cooling Degree Days at Melbourne using only
  recent data

Recent Data exhibits Global Warming CO2
Each daily CDD is added up to find the annual CDDs
9
A Weather-linked Option

• An example of a weather linked option is the
  Cooling Degree Day (CDD) Call Option.
• Total CDDs is defined as the accumulated number
  of degrees the daily mean temperature is above a
  base figure.
• This is a measure of the requirement for cooling.
• If accumulated CDDs exceed the strike, the
  seller pays the buyer a certain amount for each
  CDD above the strike.

10
Defining a CoolingDegree Day Call Option

• Strike 600 cooling degree days.
• Notional 100 per cooling degree day (above
  600).
• If, at the expiry of this contract, the
  accumulated number of cooling degree days is
  greater than 600, then the seller of the option
  pays the buyer 100 for each cooling degree day
  above 600.

11
Pay-off Chart for the CoolingDegree Day Call
Option
12
Defining a Cooling Degree Day Put Option

• Strike 600 cooling degree days.
• Notional 100 per cooling degree day (below
  600).
• If, at the expiry of this contract, the
  accumulated number of cooling degree days is less
  than 600, then the seller of the option pays the
  buyer 100 for each cooling degree day below 600.

13
Pay-off Chart for the Cooling Degree Day Put
Option
14
Returning to the Cane Grower

• Suppose that our cane grower has experienced an
  extended period of drought
• Suppose that if rain doesn't fall next month, a
  substantial financial loss will be suffered.
• How might our cane grower protect against
  exceptionally dry weather during the coming month?

15
One Approach

• One approach could be to purchase a Monthly
  Rainfall Decile 4 Put Option.
• Assume that our cane grower decides only to take
  this action when there is already a risk of a dry
  month.
• That is, when the current month's Southern
  Oscillation Index (SOI) is substantially
  negative.
• So, the example is applied only to the cases when
  the current month's Southern Oscillation Index
  (SOI) is in the lowest 5 of possible values,
  that is, below -16.4.

16
Specifying the Decile 4 Put Option

• Strike Decile 4.
• Notional 100 per Decile (lt Decile 4).
• If, at expiry of this contract, the Rainfall
  Decile is lt Decile 4, the seller of the option
  pays the buyer 100 for each Decile lt Decile 4.
• Note Decile 1 is a rainfall total in the
  lowest 10 of historical records, decile 2 is in
  the second lowest, decile 3 is in the third
  lowest, etc.
• Note Echuca (Murray River) has
• been studied using this technique.

17
Payoff Chart for Monthly Rainfall Decile 4 Put
Option
18
Outcomes for Decile 4 Put Option(for cases when
the Southern Oscillation Index is in the lowest 3
deciles - an indicator of dry conditions)

• SOI - Difference between the Darwin and Tahiti
  Pressure Across the Pacific - El-Nino

19
Evaluating the Decile 4 Put Option (for cases
when the Southern Oscillation Index is in the
lowest 3 deciles)

• 9 cases of Decile 1 yields (4-1)x9x1002700
• 6 cases of Decile 2 yields (4-2)x6x1001200
• 4 cases of Decile 3 yields (4-3)x4x100400
• Total 19 cases Total 4300

20
Evaluating the Decile 4 Put Option(for cases
when the Southern Oscillation Index is in the
lowest 3 deciles)

• The other 25 cases (5344333, Decile 4 or
  above) yield nothing.
• leading to a total of 4300 and an average
  contribution of 98 (4300/19 cases (Below
  Decile 4) 25 cases (Decile 4 and Above), which
  is the price of our put option.