Mixed forecast

Structured products

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Weather derivatives were touted as the next big thing when they burst on the scene in the late 1990s. Here was a way for utility companies to hedge against reduced energy consumption in warm winters; for insurance companies to protect themselves against multi-billion-dollar claims in the wake of devastating hurricanes; and for agricultural firms to hedge against low crop yields caused by above-average rainfall.

In fact, nearly every business is affected by the weather in some way: cold, wet Saturdays in July mean people are less inclined to shop, go on day trips, eat ice cream. Any company affected by the weather could, argued dealers, take out a derivative based on temperature, rainfall, wind or snow to hedge this exposure.

Except it didn't turn out like that. Many potential users claimed weather derivatives were too expensive, a result of wide bid/offer spreads. What's more, the effect of weather patterns on revenues was notoriously difficult to gauge for many businesses. Despite the initial optimism, weather derivatives tended to be dominated by large energy companies and reinsurers. And that's taken its toll on volumes.

Last year, the annual total notional value of weather risk contracts dropped by 57.6%, from $45.2 billion in the 12 months to March 2006 to $19.2 billion between April 2006 and March 2007, according to an annual survey carried out by PricewaterhouseCoopers on behalf of the Washington-based industry body Weather Risk Management Association (WRMA). The annual number of weather risk contracts traded on the Chicago Mercantile Exchange (CME) decreased by 30%, from 1,041,439 to 729,313 contracts over the same period.

Volumes had been increasing prior to that point, with the total notional value of weather derivatives contracts reported at $9.7 billion in 2004/05 and $4.7 billion in 2003/04 - but that's still small potatoes compared with credit derivatives, a market that got off the ground at roughly the same time. The notional principal outstanding volume of credit default swaps reached $34.5 trillion as of December 31, 2006, according to the International Swaps and Derivatives Association.

"One of the reasons for last year's slowdown in the weather derivative market was a focus away from trading seasonal weather derivatives contracts, which represented five months of exposure, to trading monthly contracts," says Brian O'Hearne, New York-based managing director of environment and commodity markets at Zurich-based reinsurance company Swiss Re, and a former president of the WRMA. "This was partly because investors wanted to trade them against various monthly commodity contracts, such as natural gas or electricity. Since monthly contracts have a lower notional value than seasonal contracts, the total notional value for the year declined." Only 1% of all the CME volume was in seasonal contracts in 2006/07, versus 51% the year before.

According to the WRMA survey, 47% of the enquiries about weather risk instruments came from energy companies, confirming this sector as the largest users of weather derivatives. Agricultural companies accounted for 14% of enquiries, while 'other', which includes insurance, made up 18%.

However, dealers are now trying to cultivate a new user-base for weather derivatives - retail investors. The survey showed that 9% of enquiries came from the retail sector, and dealers are trying to tap into this potential.

"The traditional types of investors in the weather derivatives market are energy and utility, as well as insurers, whose business is exposed to weather risk. We are currently trying to expand this group to institutional and retail markets," says Ilija Murisic, executive director, hybrid derivatives trading at UBS in London.

In May, the bank launched its Global Warming Index (UBS-GWI) - which tracks temperature-linked futures contracts on 15 US cities traded on the CME. Based on UBS analysis, the sensitivity of the UBS-GWI to 1 degsF excess of average annual temperature in each of the cities throughout a year is 73.83%.

"The index is mainly sold to investors looking to get access to a truly uncorrelated asset class with a high-return investment," says Murisic. The index started to trade at 100 on May 2 and by August 10 had risen to 124.7. Based on back-tested results, the index would have reached 221.4 on May 2 had it been launched at 100 in January 2004. The Sharpe ratio over this period was 1.57, while the correlation of the index's returns with equities, rates, foreign exchange and commodities was not more than 6%.

"This is a simple instrument for investors to gain access to the weather market. The index reflects the activity on the CME and rises as temperature expectation rises," says Murisic.

Structured products linked to the UBS-GWI index are being sold in the Nordic region, Switzerland, Italy and Taiwan, and Murisic says retail and high-net-worth investors are becoming more aware about weather, given increased understanding of global warming. "Over the past few years, retail investors have been more sensitive to environmental issues and have sought diversification in their portfolios with alternative asset classes. It is all the more appealing for retail investors to invest in the UBS-GWI given the recent extreme volatility in other asset classes," says Murisic.

Merrill Lynch, meanwhile, launched a temperature-linked product in July to allow Italian retail investors to access the weather market. The product is a two-year euro-denominated certificate, which offers an annual return based on the average annual temperature at Rome's Ciampino airport. It is 100% principal-protected and starts to pay a coupon at an average annual temperature of 16.38 degsC, with the coupon rising linearly to a cap of 16% at an average of 17.38 degsC.

"We are targeting this product at Italian agricultural businesses and retail investors. The idea for the product started out as a corporate hedge for Italian agricultural businesses, and when we realised the historic returns were quite attractive we decided to offer it as a retail product as well," says Jens Boening, London-based vice-president for commodities and weather origination at Merrill Lynch, and vice-president of the WRMA. "Retail investors would be interested in this product because weather assets are typically uncorrelated to traditional asset classes, such as stocks or bonds. It is a great tool for diversifying a portfolio." Boening says there has been a positive response to the certificate so far, with clients buying all the original EUR20 million issued.

Both UBS and Merrill Lynch say they have not been daunted by the lack of liquidity in the weather derivatives market when putting these products together. "We relied on historic temperature data for the region and our experience in the over-the-counter derivatives market to price the structure," says Boening. He would not comment on whether the bank would hedge its weather exposure, merely stating that Merrill Lynch has a global diversified weather risk portfolio. UBS, meanwhile, hedges the UBS-GWI by trading weather futures contracts for each of the 15 cities offered by the CME.

In fact, dealers say liquidity in the weather derivatives market has steadily improved since the start of the decade, even despite the drastic drop-off in volumes last year. Bid/offer spreads have tightened in some of the most liquid cities in the US, such as Chicago and New York, from 50 cooling degree days wide a few years ago to less than 10 cooling degree days wide this year, says Kendall Johnson, Stamford-based global manager of weather derivatives for interdealer broker TFS Energy. "Liquidity in the weather derivatives market has definitely increased over the past few years," he adds.

Could the emergence of weather-focused retail structured products give the market a boost? Some dealers expect volumes to increase this year, helped by the participation of a wider universe of end-users, including retail investors. "I expect there will be a strong increase in trading volumes for weather derivatives this year, with many types of investors, including retail and corporates, involved. The weather market is becoming more mature and diversified in terms of weather underlyings used, geographies covered and different types of investors," says Merrill Lynch's Boening.

But not everyone thinks the weather derivatives market is suitable for retail investors. For one thing, the number of dealers active in the market is still relatively small. If an investor wanted to sell a bespoke product linked to OTC weather derivatives, he or she would probably be restricted to dealing with the bank that sold the product. Given recent concerns about liquidity risk in the collateralised debt obligation (CDO) market, where dealers, hedge funds and institutional investors have struggled to sell CDO assets in the secondary market, some are wary about offering retail investors anything but those products referenced to the most liquid underlyings - for instance, equities.

Others argue that weather derivatives are too complex for retail investors. "It may be a long time until retail interest hits the weather derivatives market. Right now this market is one used for risk management by end-users and by investment fund managers," says Felix Carabello, director of alternative investment products at CME Group in Chicago and a director at the WRMA.

Scott Mathews, head of the weather desk at New York-based Glass Futures, a brokerage firm specialising in serving institutional energy clients, and president of commodity trading advisory service WeatherEX in New York, agrees: "At the moment, it is still too arcane and complex for retail investors. Educating commodity brokers about weather derivatives is crucial in attracting retail interest to the weather market."

Ryan Davidson

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