Chicago Mercantile Exchange Sees Growth Opportunities in Weather

The Chicago Mercantile Exchange has announced that weather derivatives could be an important growth area and hopes to launch new products to tap into demand for hedges against weather-related risk.

“It’s our view that weather risk is no different than foreign-exchange risk,” said Felix Carabello, CME director of Alternative Investment Products. “It’s a very young market that’s sort of coming out of its novelty stage.”

Speaking to a group at the Weather Risk Management Association in Chicago this week, Carabello said just under 400,000 weather derivatives contracts have traded at CME this year, putting the exchange on par to meet 2005’s annual volume of 867,384.

Open interest is at 350,000 contracts, which Carabello says “rivals more established products.” Open interest, an important measure of liquidity, is the total number of contracts that have been bought or sold, but not yet closed by an offsetting sale or purchase.

CME launched weather derivatives in 1999, but the products didn’t really catch on until 2004. Futures and options contracts based on temperatures in 18 U.S., nine European and two Asia-Pacific cities can be traded.

The contracts are traded based on indexes called HDD, or Heating Degree Day, where energy is used for heat in winter, and CDD, or Cooling Degree Day, where energy is used for air conditioning in summer. The index values are based on the average daily temperature variations from 65 degrees Fahrenheit.

Energy and tourism companies are just a few who can benefit by hedging their risk against unexpected changes, Carabello noted.

In the weather segment, Carabello said CME is continuing to pursue the best way to launch hurricane risk products and contracts tied to precipitation levels.

The impact of last year’s hurricane season has led to insurance companies no longer underwriting hurricane risk in the reinsurance base, Carabello noted.

“The only way to help shift that risk is through an index that becomes a conduit to move that risk outside the reinsurance area into the financial markets,'” Carabello said.

CME has pursued a hurricane futures contract for less than a year and is determining the best way to structure the contract.

Carabello said, for example, a contract could focus on whether a hurricane was in a certain grid square, whether it reached a certain category, or whether it exceeded a predetermined level of damage.

“It could easily be done if we just wanted to list something, but we want to list something that’s going to trade,” Carabello said. He declined to target a launch date but noted that CME wouldn’t do so during the middle of a hurricane season.

Carabello also said CME is pursuing a futures contract tied to precipitation, or rain, but said “it’s a very difficult product to create.”

Earlier this year, the CME launched a snowfall futures contract tied to the amount of snowfall in Boston and New York.

Scott Mathews, president of WeatherEX LLC, a commodity trading adviser, said some of this new volume in weather derivatives is from hedge funds that have entered the market over the past few years.

Mathews said the weather contracts provide the hedge fund a way to distinguish itself from others through its trading of a non-traditional product.

Mathews also said in the post-Enron-collapse environment, businesses became more interested in securing their trades through an exchange such as CME, rather than directly over-the-counter.

Hedging risk based on weather is still done via over-the-counter transactions, which are privately negotiated, for example, through insurance companies. The difference is an insurance company will pay out when an actual loss is incurred. However, for derivative contracts, like the ones traded at CME, they are tied to an underlying index, and are not paid based on suffering loss, but through

Though trading volume is on the rise, weather derivatives only account for a fraction of trading volume at CME, a unit of Chicago Mercantile Exchange Holdings Inc. About 5 million contracts trade daily at CME, the bulk of them on futures tied to interest rates or stock indexes.

The weather derivatives contracts are part of a growing line of alternative investment products that CME has been rolling out to offer a fuller range of hedging opportunities for clients. Among recent offerings, CME recently started trading futures on U.S. housing prices.