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Weather and weather derivatives

Weather and weather derivatives

06:28 PM

Indian economy is an agrarian one, wherein as much as almost 20 % of the GDP is wiped out during a year of bad monsoon. Research shows, more than 80% of the business activity in the world is dependent on weather. So while we can protect ourselves by wearing loads of layers on a cold day, firms facing losses because of a baking sun do not have that option!

Fashion houses, ice - cream manufacturers, building companies and sports goods manufacturers depend highly on weather for their sales and turnover. And it is this uncertainty of weather conditions that make companies pay extra moolah on commodities due to rising prices, effects of which pass onto farmers and then onto consumers. And that’s when weather derivatives act as a savior.

A weather derivative is a financial instrument used by companies to hedge against the risk of weather-related losses. Weather derivatives use weather conditions, such as city temperature, rainfall, wind speed and so on, to create different kinds of derivative instruments. The value of a weather derivative is derived from fluctuations in the weather conditions. Energy companies are the biggest users of these trades and contracts based on temperatures, thus this continues to be the most popular form of weather derivative. Big construction companies, with tight deadlines and costly penalty clauses, also turn to derivatives. So do retailers, which run big outdoor events beholden to the weather.

This is not the same as crop insurance, which is for low-probability events like hurricanes and tornados. In contrast, derivatives cover high-probability events like a dry monsoon or a less cool winter.  The weather-derivatives industry hopes that farmers will pile in to purchase hedges against sun and rain that can affect the size of their harvest. In India, subsidized government insurance schemes are already offered, but derivatives can fill the gaps or boost coverage. Awareness about weather derivative should therefore be built even stronger amongst traders and farmers so as to reduce the menacing role of moneylenders.

In India, Rabo Bank and ABN Amro have been the first off the block to introduce weather derivatives. Heating degree days (HDD) or Cooling degree days (CDD) are the most common types of weather derivatives offered by banks like ABN Amro. These banks look at the impact of monsoons on corporate bottom lines in tourism, travel, hotel industry, sports industry, event management, power, agriculture and FMCG.

However, regulations that would allow the use of weather derivatives are yet to be introduced and passed by the government of India. Associated Chambers of Commerce and Industry of India (ASSOCHAM) has already issued a plea for the Forward Contracts (Regulation) Amendment (FCRA) Bill 2010 to be approved. Implementation of this amendment will provide autonomy to the Forward Markets Commission (FMC), India’s commodity market regulator.

“The amended FCRA bill will enable the market to introduce new and innovative hedging products like weather derivatives, which can then be tailored to the risk appetite of farmers to hedge risks,” says Mr. Dhoot, President of ASSOCHAM.