Weather, Energy, and
Insurance Derivatives
Chapter 25
Options, Futures, and Other
Derivatives, 7th Edition, Copyright ©
John C. Hull 2008 1
Pricing Issues (page 581)
To a good approximation many underlying
variables in insurance, weather, and energy
derivatives contracts can be assumed to
have zero systematic risk.
This means that we can calculate expected
payoff in the real world and discount at the
risk-free rate
Options, Futures, and Other
Derivatives, 7th Edition, Copyright ©
John C. Hull 2008 2
Weather Derivatives: Definitions
(page 582)
Heating degree days (HDD): For each day
this is max(0, 65 – A) where A is the
average of the highest and lowest
temperature in ºF.
Cooling Degree Days (CDD): For each day
this is max(0, A – 65)
Contracts specify the weather station to be
used
Options, Futures, and Other
Derivatives, 7th Edition, Copyright ©
John C. Hull 2008 3
Weather Derivatives: Products
A typical product is a forward contract or an
option on the cumulative CDD or HDD
during a month
Weather derivatives are often used by
energy companies to hedge the volume of
energy required for heating or cooling
during a particular month
How would you value an option on August
CDD at a particular weather station?
Options, Futures, and Other
Derivatives, 7th Edition, Copyright ©
John C. Hull 2008 4
Energy Derivatives (page 583-586)
Main energy sources:
Oil
Gas
Electricity
Options, Futures, and Other
Derivatives, 7th Edition, Copyright ©
John C. Hull 2008 5
Oil Derivatives (page 583-84)
Virtuallyall derivatives available on stocks
and stock indices are also available in the
OTC market with oil as the underlying asset
Futures and futures options traded on the
New York Mercantile Exchange (NYMEX)
and the International Petroleum Exchange
(IPE) are also popular
Options, Futures, and Other
Derivatives, 7th Edition, Copyright ©
John C. Hull 2008 6
Natural Gas Derivatives (page 584)
A typical OTC contract is for the delivery of
a specified amount of natural gas at a
roughly uniform rate to specified location
during a month.
NYMEX and IPE trade contracts that
require delivery of 10,000 million British
thermal units of natural gas to a specified
location
Options, Futures, and Other
Derivatives, 7th Edition, Copyright ©
John C. Hull 2008 7
Electricity Derivatives (page 585)
Electricityis an unusual commodity in that it
cannot be stored
The U.S is divided into about 140 control
areas and a market for electricity is created
by trading between control areas.
Options, Futures, and Other
Derivatives, 7th Edition, Copyright ©
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Electricity Derivatives continued
A typical contract allows one side to
receive a specified number of megawatt
hours for a specified price at a specified
location during a particular month
Types of contracts:
5x8, 5x16, 7x24, daily or monthly exercise,
swing options
Options, Futures, and Other
Derivatives, 7th Edition, Copyright ©
John C. Hull 2008 9
How an Energy Producer
Hedges Risks
Estimate a relationship of the form
Y=a+bP+cT+
where Y is the monthly profit, P is the
average energy prices, T is temperature,
and is an error term
Take a position of –b in energy forwards
and –c in weather forwards.
Options, Futures, and Other
Derivatives, 7th Edition, Copyright ©
John C. Hull 2008 10
Modeling Energy Prices (equation
25.1, page 585)
d ln S [(t ) a ln S ]dt dz
For oil a is about 0.5 and is about 20%;
for natural gas these parameters are about
1.0 and 40%; for electricity they are about
15 and 150%.
Options, Futures, and Other
Derivatives, 7th Edition, Copyright ©
John C. Hull 2008 11
Insurance Derivatives (page 586)
CAT bonds are an alternative to traditional
reinsurance
This is a bond issued by a subsidiary of an
insurance company that pays a higher-
than-normal interest rate.
If claims of a certain type are above a
certain level the interest and possibly the
principal on the bond are used to meet
claims
Options, Futures, and Other
Derivatives, 7th Edition, Copyright ©
John C. Hull 2008 12
