The world's first exchange-traded weather derivative began trading on September 22, 1999, at the Chicago Mercantile Exchange (CME). Weather derivatives originated initially as over-the-counter (OTC) products in the US less than two years ago. However, as participants sought greater liquidity, price discovery and transparency, the market had to move to an exchange-trading environment. The CME has initially listed temperature-related heating degree-day (HDD) index futures for four US cities but plans to add cooling degree-day (CDD) indices as well at more locations.

A degree-day (DD) has emerged as a common measure of temperature, and measures the deviation of a day's average temperature from the reference. An HDD occurs when the average temperature is below the reference, and a CDD when the average temperature is above. The CME contracts are based on an index that measures the extent and frequency that theaverage temperature drops below 65 degrees fahrenheit (the reference) cumulated monthly across the relevant city.

The futures contracts pay $100 per each point movement in the index. Earth Satellite Corporation, an independent entity, calculates the HDD index ensuring transparency and independence in the benchmark. Weather derivatives are financial products that enable an organisation to offset the financial risk due to a weather variable. They emerged as an offshoot of insurance. Insurance is expensive and requires a demonstration of loss (of assets or of profits).

While well suited to calamities and extreme weather events such as earthquakes and typhoons, insurance does not work well with the uncertainties in normal weather. Consider insuring the loss in revenues for an umbrella manufacturer if the monsoons are a month late, or of the air-conditioner company if they are a month early.

Weather derivatives could easily be adapted for use within India using rainfall, which is a more important variable inour context, as a benchmark.

A rain day (RD), defined as a 24-hour period during which precipitation was in excess of the reference (20 mm), and an index cumulating the number of RDs between June 1 and September 30 can be used to compute pay-off.

Not everybody's exposure to monsoons is the same, and offsetting exposures of different entities will help in the emergence of a robust market. In the US, weather affects an estimated 20 per cent of the economy. In India, the figure would be higher. Fifty per cent of agriculture is based on rain-fed irrigation, and monsoons determine rural demand patterns. On a cursory glance, one can see that there are many industries besides agriculture that are directly impacted by rainfall. For example, fertiliser offtake, agricultural commodity prices, water utilities, energy consumption, construction demand/costs, etc.

The US weather market was driven primarily by energy producers and utilities, facing deregulation and competition and seeking to manage weather risks.However, its use is more generic--for protecting revenues when weather depresses demand or results in increased costs. And if the market is to develop or expand, there has to be demand from more diversified businesses like retail, manufacturing, and agriculture.

Once end-users determine that weather too is a risk they would like to actively manage and hedge, there is unlikely to be a shortage of counterparts. Institutional investors looking for new asset classes not correlated with existing markets and banks offering integrated risk, the management would be more than willing to absorb the risk.

The pricing of weather derivatives is, of course, another issue. One cannot buy or sell the underlying, be it sunshine or rain. Positions have to be hedged with offsetting positions and one cannot create a risk-free portfolio by combining the derivative with its underlying (as done for other derivatives). Though Caps, Collars and other exotics in weather are offered, the closed-form solution of classicalBlack-Scholes option theory has no application. Weather contracts are based more on forecasting than on mathematical derivation; it is the meteorologist who holds the sway and not the mathematician. Information on past weather behaviour and an understanding of the dynamics of the environment is essential.

Predictability of even large-scale weather systems beyond a week is difficult at best. Even though it is a nascent market and has not as yet extended beyond the US, almost 2,000 "weather" swaps (private, off-exchange contracts between individual entities) with an estimated value of close to $3 billion have been negotiated. India needs to take some lead from events in other markets. Can we start with simple but overdue (equity) index trading?

(The author is head of treasury marketing of a leading foreign bank. The views expressed here are his own and not that of his bank)