Thursday, August 23, 2007

Trading as an adaptation tool: Financial instruments to handle weather risk

MarketWatch: …As hurricanes and variable weather make a more noticeable dent on businesses' bottom lines, financial institutions are stepping up to give individuals greater protection against the perceived risks associated with weather changes. Seen as an outgrowth of the traditional futures markets, these new weather-related contracts may help curb the financial disruption caused by climate change.

The Chicago Mercantile Exchange, the nation's largest futures exchange, which first started trading weather derivatives in 1999, listed its first hurricane futures and options in March. The derivatives are geared toward insurance companies, municipalities and energy companies that seek to transfer the risk of hurricanes to capital markets…

The front contract expires when a hurricane makes landfall, with the expiration tied to the Carvill Hurricane Index. There are geographic contracts for the Gulf Coast, Florida, the southern Atlantic Coast, the northern Atlantic Coast and the eastern U.S.

The Chicago Merc also lists weather-related contracts for many cities that are based on temperatures, snowfall and other factors. Last year, the exchange said, it traded weather contracts with a notional value of about $22 billion. It's on pace to trade more in 2007, it added.

"There is great acceptance that companies need to manage weather risk," said Felix Carabello, the director of alternative investment products at the Chicago Merc. A more variable climate equals more uncertainty about profits, he said.

"You can't predict the weather, but with some of these contracts you can dampen the volatility in earnings due to erratic weather," Carabello said, adding that reinsurance and energy companies have been big early adopters, while hedge funds and banks are increasingly exploring hurricane- and other weather-related risks.

Earlier this year, the New York Mercantile Exchange launched contracts allowing real-time trading of property-damage risk exposure, including hurricane risk. The contracts are based on a property-damage index maintained by the reinsurance company Gallagher Re….

HedgeStreet, a regulated online exchange, also trades hurricane futures and is looking into more potential products that would allow individuals to play global warming. The hurricane contracts are based on insurance-claims data from Insurance Services Offices….

…HedgeStreet's strategy is to nurture the market and generate a retail community of traders to validate the concept. And with more exchanges going public and competition heating up, they're getting more aggressive in listing new products as institutional investors look to hedge weather risk….

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