Trading weather related risk

Channels: Investors, Markets, Insurance

Companies: CME Group

CME Group Overview:

As the world's leading and most diverse derivatives marketplace, CME Group is where the world comes to manage risk.  Through its exchanges, CME Group offers the widest range of global benchmark products across all major asset classes, including futures and options based on interest rates, equity indexes, foreign exchange, energy, agricultural products, metals, and alternative investment products, including alternative investment products based on weather and real estate.  CME Group provides electronic trading globally on its CME Globex platform.  CME Group's products and services ensure that businesses around the world can effectively manage risk and achieve growth.

Traders from all over the world come to a futures exchange for a stable, regulated, transparent and liquid venue on which to buy and sell futures contracts. These exchanges were born on the streets of Chicago, eventually moving indoors to the bustling open-outcry pits we’ve historically associated with the concept of trading. Today’s exchanges are almost entirely electronic, executing millions of trades per second and offering market participants around-the-clock access to the global markets. CME Group’s clearing house stands at the center of every trade, acting as the buyer for every seller and the seller for every buyer, ensuring that each side can make good on the terms of the trade and protecting the integrity of the market.

Impact of Weather:

Many conversations begin and end with the weather. That’s probably because weather is one of the most common and pervasive risk factors for individuals and businesses. Weather influences demand for energy, variations in crop yield and fluctuations in consumer prices. It creates costly delays in construction and influences home improvement company sales. It causes postponements and cancellations in travel, and makes or breaks seasonal retail sales and activities. Weather can affect the revenues and earnings of companies doing business anywhere across the globe.

Weather cannot be controlled, but CME Group’s products can help investors and businesses manage their weather-related risk. CME Group’s Weather products offer the ability to manage volumetric risk or the risk due to variability in sales revenues, caused by weather-related fluctuation in levels of consumption. Using weather products can help companies optimize their operations and reduce earnings volatility. Benefits of participating in CME Group’s global weather risk management market include:

  • Stabilized cash flow and earnings
  • Reduced risk
  • Increased opportunity to focus on core businesses
  • Further strengthening of the balance sheet
  • Maintenance of adequate liquidity via improved and predictable cash flow

Market Participants:

All kinds of people come to futures exchanges, to buy and sell futures and options contracts. They may work for banks, corporations or governments. They may be livestock ranchers, investment managers, construction planners, farmers or food manufacturers. Really, futures trading involves just about anyone in the world who wants either to manage the risk of fluctuating prices or profit from those fluctuations. But whoever they are, and wherever they came from, these traders are interested in two types of trading: hedging and speculating. Hedgers transfer risk, and speculators absorb that risk. It takes both types of traders to bring balance to the market and keep trades moving back and forth.

Hedgers

The hedger buys futures contracts because he wants to protect himself from price swings in the future. By using futures to lock in a future price for a product, he makes his costs – and his profits – more predictable. In other words, he trades futures to drive risk out of his business. Hedgers that use Weather products to hedge risk include companies in energy-related businesses, as well as agricultural firms, re-insurers, retailers, and companies involved in tourism and travel. Many over-the-counter (OTC) weather derivative traders also trade CME Group’s Weather products for purposes of hedging their OTC transactions.

Speculators

The speculator accepts price risk in pursuit of profit. Speculators have no interest in owning the product being traded, but they are interested in the contracts for those products. Think of it like investing – buying and selling futures contracts in order to make a profit when prices move in the right direction. These investors include every type of participant from hedge funds, prop firms and large banks to active individual traders.

Temperature Based Products:

CME Group offers Heating Degree Day (HDD) and Cooling Degree Day (CDD) temperature based weather products for the United States and Europe. (See Table Below). 

The HDD and CDD Indexes identify what are called degree days. A degree day is a measure of how much a day’s average temperature deviates from 65 degrees Fahrenheit (or 18 degrees Celsius outside the United States). Average daily temperature is defined as the average of a day’s maximum and minimum temperature. Index values are multiplied by a cash amount for settlement. All of our Weather contracts are settled in cash.

To determine an HDD value, subtract a day’s average temperature form 65. For example, if the average daily temperature was 40 degrees, you would subtract 40 from 65. For cities outside the United States, the process is the same, except the calculation is done using 18 degrees on the Celsius scale instead of 65 degrees on the Fahrenheit scale. If the temperature exceeded 65, the value of the HDD would be zero.

To determine a CDD value, subtract 65 from a day’s average daily temperature. For example, if the average daily temperature was 80, you would subtract 65 from that number. If the temperature was lower than 65, the value of the HDD would be zero.

The Cumulative Average Temperature (CAT) Index is used for the summer season contracts in Europe. The CAT Index tracks average daily temperatures over a calendar month in a given city, and that average number is used to calculate a Weather contract value – there is no baseline 65 degree temperature with which HDD or CDD is established. Each particular CME European CAT Index is the accumulation of daily average temperatures over a calendar month or season. The accumulation period of each CME European CAT Index futures contract begins with the first calendar day of the contract month and ends with the last calendar day of the contract month.

Weather Futures and Options Codes
Heating (HDD) Futures and Options
 CITY CODEOCTNOVDECJANFEBMARAPR
U.S.
Atlanta H1 H1V H1X H1Z H1F H1G H1H H1J
Chicago H2 H2V H2X H2Z H2F H2G H2H H2J
Cincinnati H3 H3V H3X H3Z H3F H3G H3H H3J
New York H4 H4V H4X H4Z H4F H4G H4H H4J
Dallas H5 H5V H5X H5Z H5F H5G H5H H5J
Las Vegas H0 H0V H0X H0Z H0F H0G H0H H0J
Minneapolis HQ HQV HQX HQZ HQF HQG HQH HQJ
Sacramento HS HSV HSX HSZ HSF HSG HSH HSJ
EUROPE
London D0 D0V D0X D0Z D0F D0G D0H D0J
Amsterdam D2 D2V D2X D2Z D2F D2G D2H D2J
Cooling (CDD) Futures and Options
 CITY CODEAPRMAYJUNJULAUGSEPOCT
U.S.
Atlanta K1 K1J K1K K1M K1N K1Q K1U K1V
Chicago K2 K2J K2K K2M K2N K2Q K2U K2V
Cincinnati K3 K3J K3K K3M K3N K3Q K3U K3V
New York K4 K4J K4K K4M K4N K4Q K4U K4V
Dallas K5 K5J K5K K5M K5N K5Q K5U K5V
Las Vegas K0 K0J K0K K0M K0N K0Q K0U K0V
Minneapolis KQ KQJ KQK KQM KQN KQQ KQU KQV
Sacramento KS KSJ KSK KSM KSN KSQ KSU KSV
EUROPE
London G0 G0J G0K G0M G0N G0Q G0U G0V
Amsterdam G2 G2J G2K G2M G2N G2Q G2U G2V
Heating (HDD) Seasonal Futures and Options
ATLANTA*ENDEND
StartMARFEB
NOV H1XH  
DEC   H1ZG
* Replace city code for appropriate city.
Cooling (CDD) Seasonal Futures and Options (CAT for London and Amsterdam)
ATLANTA*ENDEND
StartSEPAUG
MAY K1KU  
JUL   K1NQ
* Replace city code for appropriate city.

For additional information and educational materials regarding CME Group’s Weather products, please visit www.cmegroup.com/weather.