Question

Examine the concept of weather derivatives and examine how they are designed to operate. Make a case for the introduction of weather derivative for sports in Ghana.

Answer 1

Answer to finance question

Concept of Weather derivatives: Weather means the situation of temperature and wind at particular place on the earth. More broadly, rainfall and snowfall can also be included in word weather. One of the most common feature of the weather is that it keep changing. There is overall impact of weather on health and habits of people of a particular place. That means, a business is also dependent on the weather of a particular place like winter wears are sold mostly in winter season and light wears are sold in summer.

Now, let us understand the Weather derivative from this perspective. Weather derivatives are those financial products which are used to hedge the risk of loss due to change in weather. Most of the businesses are weather sensitive and their demand/supply depends on the weather. There is a buyer and a seller of these financial products/instruments. The seller agrees to take risk of change in weather or disaster due to change in weather in return of premium. If something goes wrong due to change in weather, there is loss to the seller as the buyer will claim the agreed amount. This is short of medical or accidental Insurance.

How these are designed to operate: Weather derivatives are part of risk management and used by the companies involved in business of hydroelectricity, farming, sports and tourism. Commonly used derivatives are as below

Temperature

Rainfall

Snowfall

Hurricanes

Wind

Most commonly used derivative is temperature. It also include future or option contracts linked to heating degree day (HDD) and cooling degree day (CDD) indices with final pay-outs linked to the index. 18 degree Celsius is assumed to be ideal temperature where no heating or cooling is required. There should be a period of say 30 days. HDD are calculated as the number of days in a set period, multiplied by differences in the average temperature and 18 degree Celsius. CDD are reverse, measuring of number of days that cooling is required when the average temperature exceeds 18 degree Celsius

Other weather derivatives are linked to snowfall, rainfall, hurricanes and frosts. Hurricane indices include factors such as the number of named hurricanes, wind speed and hurricane radius. Frost derivatives are linked to temperatures at which frosts occur.

Settlements of the derivatives are done in cash.

Introduction of weather derivatives for sports in Ghana

Overall weather system of Ghana is divided in 2 parts as shown below

Dry Season: November to March

Average temperature in dry season is 24º C to 31º C

Wet Season: April to October

Average temperature in wet season is 22ºC to 31ºC

The overall impact of weather on sports is seen in occurrence of events and attendance of people. In turn, this will impact the overall of revenue of the sports.

Looking at the temperature history of Ghana, we should organise the event of sports in dry season when there is comfortable temperature and little rain. However, the organisers of the event can buy the derivative of rainfall and temperature for security and keep safe from loss.

References

Alaton, P., Djehiche, B., & Stillberger, D. (2002). On modelling and pricing weather derivatives. Applied mathematical finance, 9(1), 1-20.

Cao, M., & Wei, J. (2004). Weather derivatives valuation and market price of weather risk. Journal of Futures Markets: Futures, Options, and Other Derivative Products, 24(11), 1065-1089.