Ilija Murisic - Alternative Asset Markets Articles Financial Times, Wall Street Journal, Reuters, Risk Magazine, Carbon Emission, Freight, Shipping Keywords: Weather, Weather Derivatives, Carbon Finance, Carbon Emission, C02, HDD, CDD, CME, EUA, CER, FFA, futures, climate change, Index, Kyoto, UBS, derivatives, hybrids, trading, structured products, china, commodities, port congestion, capital markets, freight, shipping

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18. Risk Magazine – July 08

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25. Weather derivatives
The weather derivatives market continues to gain end-user, hedge
fund and investor interest. Roderick Bruce examines the forecast and
finds a silver lining on the current Wall Street cloud
Every cloud...
After a barren year in 2006/7, the weather tion to the headline numbers in the PwC
derivatives market has come storming back. survey, which have grown quite a lot over the
Notional value of over-the-counter (OTC) years, perhaps an even better barometer of the
and exchange-based weather trades on the market’s health is that end-user hedging trans-
Chicago Mercantile Exchange (CME) rose actions have been growing at a steady pace
76% between April 2007 and March 2008 since the inception of the market,” says Martin
to reach $32 billion, while contracts traded Malinow, CEO of Galileo Weather Risk
rose by 35% to 985,000 over the same period, Management and president of the Weather
according to a survey by Pricewaterhouse- Risk Management Association (WRMA).
Coopers (PwC). The weather markets look ripe for further
The market had reached a high of $45 billion growth. End-users are coming from a variety
in 2005/2006, and its decline the subsequent of new sectors, with increasingly advanced
year led many to question its longevity. “Since structured deals making risk transfer more
its inception, the weather markets have faced effective, and innovative origination compa-
challenges, but they continue to be resilient,” nies such as Storm Exchange and Weather-
says Felix Carabello, director of alternative Bill are offering improved access to derivatives
investments at CME Group. for small businesses. Most significantly, as the
Carabello says the 2006/2007 drop in trading winds of change sweep away investment banks
volume came from a period of staff reorgani- and insurance companies on Wall Street, hedge
sation within market participants. He noted funds and reinsurers are turning to the market
that traders’ risk appetite was reduced as in increasing numbers, as are investors seeking
they settled into their new roles. “Because a uncorrelated assets to diversify portfolios.
number of traders were changing jobs, we saw
a decrease in volumes,” he says. “The moves Energetic growth
were caused by market evolution and organic Market participants say that around 90–95% of
growth. It was like a kid losing its milk teeth global weather derivatives volumes come from
before it matures.” the US, with Europe supplying the bulk of the
End-user hedging business – particularly remainder, with some trades occurring else-
within the energy sector – remains the pillar where, particularly Japan, Australia and India.
that the weather market is built on. “In addi- The US energy sector, which pioneered the
weather derivatives market in 1998 with a deal
between Koch Industries and Enron, remains
“A barometer of the market’s health the biggest end-user, according to brokers.
is that end-user hedging transactions A CME Group / Storm Exchange survey
carried out in April, which polled 205 risk
have been growing at a steady pace and finance mangers across the US, found that
74% of respondents in the energy sector had
since the inception of the market” attempted to quantify the impact of weather on
Martin Malinow, Galileo Weather Risk Management & WRMA their business, and 35% had actually employed
26 energy risk energyrisk.com

26. weather hedges to manage that
risk. That compares to 29% of The weather
retailers – none of whom had derivatives market
employed derivatives. has come storming
“Energy companies are still back after a barren
the number one participant,” year in 2006/7
says Bill Windle, who began
trading weather derivatives
at Enron in 1999 and is now
managing director at RenRe
Investment Managers, a weather
risk management company.
“More and more unregulated
energy providers are seeking
our services because they do not
benefit from regulatory mecha-
nisms that limit their exposures
– they’re in a truly free market,
so volumetric and price expo-
sure is significant.”
More energy compa-
nies – producers, marketers
and consumers – are getting
involved in the market as
product offerings advance.
©iStockphoto.com/Tobias Helbig
Significant new volumes are
coming from cross-commodity
deals that allow hedgers to offset
both volumetric risk with tradi-
tional derivatives and price risk
with more complex structures.
For example, a deregulated
natural gas provider depends on cold weather “There’s quite a bit of appetite for these
to drive sales. While the company can esti- products,” says Windle.
mate sales based on temperature predictions That appetite is not limited to the US.
(using heating or cooling degree day – HDD Whereas energy companies in Europe tradi-
/CDD – indexes) and create a supply port- tionally hedge volumetric risk from warm
folio accordingly, if the winter is colder than winters, many gas distribution companies
expected then the company will be forced to in the UK now hedge price risk from colder
enter the market to buy more gas when prices than expected winters. “If it’s much colder
are at their highest. than normal, short-term natural gas prices in
To hedge this risk, the company can buy a the UK tend to spike more than they do on
natural gas-linked weather derivative. “If the the European continent,” says Jens Boening,
temperatures are over a certain strike we’ll sell managing director Europe & Asia at Weath-
the company natural gas at a fixed or indexed erBill, which provides customised products to
price, allowing them some comfort that they end-users from utilities to small businesses.
won’t have to purchase in a high price envi- Boening points out that end-user demand
ronment,” says Windle. in Europe is not met efficiently in the traded
Should the winter be warmer than expected, market, as standardised products (such as those Nicholas Ernst, Evolution
a put position then allows the company to sell based on HDDs at London Heathrow) leave Markets: “Weather is becoming
any excess inventory at the end of the season significant basis risk. a cross-commodity market, and
at a predetermined or indexed price, allowing Cross-commodity products are therefore around 20% of our business
the company to better match their volumetric attracting new end-users to the market, now comes from these deals, up
and price exposures in one combined product. and increased volumes from established from about 10% a year ago”
October 2008 energy risk 27

27. Weather derivatives
counterparties. “Weather is becoming a of millions of dollars, whereas only a year
cross-commodity market, and around 20% ago we were dealing with more middle-
of our business now comes from these deals, market clients.”
up from about 10% a year ago,” says Nicholas Brian O’Hearne, managing director, finan-
Ernst, head of the weather derivatives group cial products at Swiss Re, says that agriculture
at broker Evolution Markets. “The growth in is clearly the fastest growing end-user sector,
the market is not just coming from new end- as awareness of weather’s impact on crop
users, but also increased risk transfer from the yield – and how to hedge this risk – improves
natural gas, power and heating oil markets.” across North and South America. “We’ve
seen interest from Australia, South Africa
– anywhere with an agricultural economy has
a need for weather derivatives,” he says.
“WeatherBill will de nitely give the One such economy is India’s, where 55% of
end-user market a boost” the population (around 621 million people)
depend on agriculture for their livelihood. The
Jens Boening, WeatherBill
sector contributes 18% of India’s GDP, equiva-
lent to $748 billion. Weather risk is concen-
Harvesting new business trated in precipitation: 75% of the country’s
Advances in deal structuring, combined with annual rainfall of 110 centimetres occurs during
soaring grain prices, have drawn significant the summer monsoon season between June and
interest in weather risk hedging from the agri- September. In addition, 26% of India’s power
culture sector. “There is weather risk in the generation comes from hydropower.
entire agricultural value chain, only a portion “Higher or lower than normal rainfall can
of which is covered by Federal crop insur- create a huge problem for the economy, partic-
ance,” says the WRMA’s Malinow. “At these ularly large sections of the rural population,”
unprecedented price levels, there is more abso- says Kolli Rao, chief manager of the Agri-
lute value to lose than ever before.” cultural Insurance Company of India (AICI).
Weather risk manager and information “Weather derivatives and insurance could
provider Storm Exchange has seen its busi- therefore be a huge market here.”
ness grow dramatically, thanks in no small part Janani Akhilandeswari, a consultant at The
to the agricultural sector. The company has Centre for Insurance and Risk Management
tripled its staff in the past 12 months, hiring (CIRM), estimates that India’s OTC weather
experts in agronomy and agricultural mete- derivatives market is worth around $1 billion.
orology to meet growing demand. Storm At the moment, exchange-traded weather
Exchange has developed crop-specific indexes, derivatives are not permitted under Indian law
based on how weather impacts yield and crop as they are “intangible assets”, but a bill being
growth, and offers structured derivative prod- considered by the government is likely to
ucts around them. allow trading in commodity options, weather
“The convergence of energy risk and agri- derivatives and index futures within the next
cultural risk is now more prevalent than ever, 12 months. Index-based weather insurance
given the effect of yield and price volatility products currently meet the demands of the
on many of the largest ethanol producers,” agriculture sector.
says David Riker, president and CEO of “We are currently working with the National
Storm Exchange. “The deals we’re doing Commodity and Derivatives Exchange
now are multi-year contracts worth hundreds [NCDEX] in designing and pricing exchange-
traded weather derivative products to be traded
once the regulatory barriers are lifted,” says
“Since its inception, the weather markets CIRM consultant Rupalee Ruchismita. “We
see huge potential in this market.” The Multi
have faced challenges, but they continue Commodity Exchange of India (MCX) is
to be resilient” also said to be considering launching weather
derivatives, according to AICI’s Rao.
Felix Carabello, CME Group Kendall Johnson, managing director and
global head of weather derivatives at broker
28 energy risk energyrisk.com

28. TFS Energy, says his team will broker Indian Index. Launched in April 2007, the index
exchange-traded weather contracts when they offers institutional and private investors expo-
are launched. “We’ve had global enquiries sure to rolling front-month weather futures
regarding the contract – such a launch would contracts on the CME, for cities in the US,
seem likely based on the success that the World Europe and Japan. It has attracted $145
Bank has had in starting to use derivatives million in investment so far.
to ease the effects of famine and droughts in Weather derivatives contracts are generally
Africa,” he says. for one month out to six months. “Using the
Swiss Re has recently added two staff to its index we take a different approach: we can
Mumbai office to take advantage of future structure long-dated trades, offering a long
opportunities in India. In the short term, investment timeframe to our clents,” says Ilija
O’Hearne expects further growth to come Murisic, executive director, hybrid derivatives Ilija Murisic, UBS: “Using the
from agriculture in the US. “As the CME trading at UBS, who created the index. index we take a different
Group has bought [agricultural exchange] The index lends itself to the creation of struc- approach: we can structure
CBOT, we may see more weather and grains tured solutions, blending weather with other long-dated trades, offering
being traded together,” he says. “Late planting asset classes like equities, commodities and a long investment timeframe
of crops has driven concern over freeze risk, carbon, says Murisic. “We have structured to our clents”
so there may be increased trading of CME trades blended with equities indices such as the
monthly weather contracts against corn or Standard & Poor’s Clean Energy Index, or the
soybeans exposed to that risk.” S&P Global Water Index or other commodities
like crude oil.”
Open to investors Murisic says the index is probably the largest
While new end-user hedging business may presence in the market, estimating that, not
be adding to volumes in the weather market, including options, it holds 40% of weather
significant interest also comes from North futures positions. Indeed the index’s first major
American commodity hedge funds offsetting transaction in the market, an auction held
weather risk to their positions in the natural by TFS Energy, boosted open interest on the
gas and power markets. CME by 13%, and had a notional value of $64
“We’ve had hedge funds talking to us for million. The auction solicited offers on May-
years, but until recently they haven’t partici- September CDD-swaps for 11 US cities.
pated because they haven’t been able to TFS Energy’s Johnson says the fact that the
trade enough volume to make it worth their market was able to accommodate such a large
while,” says one weather broker who wished risk transfer without price slippage is testament
to remain anonymous. to the maturity and depth it now has. The
As liquidity has grown, weather-focussed auction format helps to build liquidity where
funds have started to emerge, too. One such it was previously lacking. “The auction might
hedge fund is the Cumulus group of funds, come from one country and place the risk in
which have total assets under management of two different countries or time zones,” says
around $100 million. A “substantial part” of Johnson. “It’s becoming a truly global market
this is allocated to front-month CME-cleared and the auction format helps us to cover that.”
weather derivatives according to Peter Brewer, CME Group’s Carabello says the UBS
Cumulus’ chief investment officer. He says Global Warming Index is “really smart”, and
that commodity hedge funds – particularly has changed the complexion of the market.
those trading natural gas – now account for “Now, a completely different kind of risk
more than half of interdealer weather deriva- appetite exists in the market,” he says. “It
tives trades. However, he doubts there will be has validated what the market does, and now
an increase in funds purely trading weather companies are looking at climatic phenomena CIRM’s Janani Akhilandeswari
derivatives. “Only the best can survive in that and securitising it to become a yield- estimates that India’s OTC
framework and many have tried and failed producing asset for their clients.” weather derivatives market is
previously,” says Brewer. The index’s initial summer hedges were worth around $1 billion
Hedge funds wanting to trade large volumes carried out through TFS, and according to
in the market now have the ability to deal sources familiar with the situation, UBS
with a counterparty of unprecedented size carried out the index’s first winter hedge with
and risk appetite: the UBS Global Warming a direct, bilateral deal in late August. Hedge
October 2008 energy risk 29

29. Weather derivatives
“The auction might come from one country Investors may be poised to play a major role in
and place the risk in two di erent countries the weather market’s expansion, but there is
a consensus among participants that growing
or time zones. It’s becoming a truly end-user business is the key to assuring long-
term market integrity. “From the beginning
global market and the auction format people thought our markets would be revolu-
helps us to cover that” tionary, but they have been evolutionary,” says
Kendall Johnson, TFS Energy RenRe’s Windle. “There is no next big thing
that will come in and double market volumes,
funds were reportedly keen to trade as the but I’m confident that there will be continued
index was a counterparty of unprecedented double digit year on year growth in the trading
size in the market. of weather-related products.”
Some participants aren’t so enthusiastic
though. “When UBS enters the market it Bright forecast
creates a ripple effect,” says one weather One platform seeking to harness the global
market participant. “It’s a problem for the potential of weather risk management is
market when someone puts out an auction, WeatherBill, by offering a service that allows
instead of taking a more calculated approach to businesses to customise, price and buy weather
execution. When someone comes in and shows coverage online. Since being founded in 2006
their entire hand it pretty much paralyses the it has protected a diverse range of clients, from
market for a lengthy period of time.” travel companies to car washes and hair salons.
Another participant observes that, as the The company itself does not actively trade
index is weighted for locational liquidity the market, but rather develops a portfolio of
rather than seasonal liquidity, the exposures offsetting – negatively correlated or uncorre-
are greater in October to April, instead of lated – weather derivative contracts.
being weighted towards the more liquid mid- WeatherBill offers online access to around 20
season. “Conceptually it’s great, but I ques- different contract types combining tempera-
tion the longevity of it, given the way it’s being ture, precipitation, snow and frost across seven
executed,” he says. countries including the US, UK and Germany.
However, the majority of feedback from “We are the first to offer this level of custom-
the market on the UBS index is positive. isability in terms of the indices available and
“There’s now plenty of liquidity in the market weather stations being offered – we will defi-
to absorb structures like this,” says Swiss Re’s nitely give the end-user market a boost,” says
O’Hearne. “Investors are looking for diver- WeatherBill’s Boening, formerly of Merrill
sification, and weather derivatives offer very Lynch and vice-president of the WRMA. “Our
good non-correlated returns.” mission is to democratise the weather market.”
Murisic told Energy Risk that he is now WeatherBill is currently seeking registration
developing an investor index based on poten- with the UK’s Financial Services Authority,
tial Indian precipitation contracts, to be which will allow it to offer its products to
listed on the NCDEX. “The Indian monsoon every UK business. The level of granularity
derivatives market could be one of the world’s offered is very different to the standard-
largest in terms of volume,” he says. He ised CME contracts that have so far been the
is also hoping to develop an index for the market driver. “Companies like WeatherBill
burgeoning hurricane derivatives market (see and Storm Exchange provide an invaluable
‘Hurricane derivatives’ box). service, a different kind of risk transfer tool
“Higher or lower than normal rainfall can create a huge problem
for the economy, particularly large sections of the rural population
[in India]. Weather derivatives and insurance could therefore
be a huge market here”
Kolli Rao, AICI
30 energy risk energyrisk.com

30. Weather derivatives
“The good news is that there is new to CelsiusPro, a Europe-focused platform
similar to WeatherBill, as a signal that online
appreciation that falling asset prices don’t origination could be the way forward.
With end-user and investor interest on the
change the temperature in London” rise, the forecast looks bright for continued
Martin Malinow, Galileo Weather Risk Management & WRMA growth in weather derivatives trading, despite
the testing times currently being experienced
from us,” says CME Group’s Carabello. “It’s in the global markets. Indeed, the very nature
more customised, less commoditised.” of the weather market means it may benefit as
Market veterans Brian O’Hearne and Bill institutions seek diversification.
Windle view WeatherBill’s emergence as the Malinow is cautiously optimistic. “We haven’t
next step for the market. Windle feels the seen much impact on weather markets so far,
increased liquidity will benefit all market but it would be naive to think there won’t be
players. “The tide will rise, and as it rises it will some fallout given the general credit contraction
lift all boats,” says Windle. “I wish WeatherBill and deleveraging we have been facing,” he says.
success, because it will be beneficial to all of us.” “The good news is that there is new apprecia-
O’Hearne meanwhile points to Swiss tion that falling asset prices don’t change the
Re’s agreement to provide risk capacity temperature in London.”
Hurricane derivatives
Index-based hurricane futures and options, launched on the CME mph winds would score 2.5 on the index. Hurricane Katrina would
in March 2007, stand at the crossroads between the insurance / have scored 19. “The Carvill index is a more precise proxy for
reinsurance industry and the capital markets. The products were storm damage and intensity than the Saffir-Simpson scale [which
formulated in a joint-venture between specialist reinsurance rates hurricanes in categories 1 to 5]” says Martin Malinow of
company Carvill, the index provider, and CME Group as a result Galileo Weather Risk Management. “It’s a purely parametric index,
of the devastating 2005 hurricane season, which caused an so it’s effectively a weather derivative and seems to be a product
estimated $79 billion worth of damage. Such was the hit on that’s here to stay.”
the insurance market that some claims from Hurricane Katrina Nicholas Ernst of Evolution Markets, which recently set up a
remain unsettled. desk to broker cat bonds, ILW derivatives and the CME’s hurricane
“The problem that the reinsurance companies faced was a futures, says that hedge funds prefer to trade the CME/Carvill futures
concentration risk – companies had been warehousing risk so it as the index format is ideal for algorithmic trading. “The problem
was concentrated too much in one space,” says CME Group’s Felix is that it doesn’t fully cover all insurances risks – it leaves significant
Carabello. “Some reinsurance companies believe that warehous- basis risk,” he says. “Right now it’s maybe too big a leap from the way
ing of risk was an unsustainable business model and they realize business is traditionally done, but the market is two or three years
that they have to shed their risk through different types of coun- away from really exploding.”
terparties accessible through CME Clearing.” After little interest in 2007, an active 2008 storm season has seen
Insurance companies previously insured their risk through a 32,600 hurricane contracts traded on the CME up to August this
reinsurance contract called an Insurance Loss Warranty (ILW), year; notional value has yet to be calculated, according to the CME.
brokered by companies such as Aon or Guy Carpenter. Now prod- Swiss Re’s Brian O’Hearne says that more point-specific and
ucts such as catastrophe bonds, which pay out to investors based location-specific products have helped to encourage insurance
on large weather events, or ILW-based insurance futures (traded companies to trade on exchanges. “Insurance derivatives are
on London-based Insurance Futures Exchange, IFEX) are allowing poised for significant growth,” he says.
hedge funds, investors and energy companies to hedge hurricane One participant who wished to remain anonymous says that
risk, at the same time diversifying the insurance market. many insurance hedge funds are up 10-15% for the year, because
The CME contracts have increased accessibility to the market, as they are uncorrelated to floundering financial markets. “With AIG
they do not feature an indemnity piece; no receipt for loss needs having gone belly up there will be more reinsurance opportuni-
to be shown to guarantee a payout (unlike ILWs). “With these ties,” he says. “The fact these assets have done well when every-
futures you can parametrically calculate the risk and infer statistical thing else has performed poorly means there will be significant
losses, and it settles immediately,” says Ilija Murisc of UBS. “For a capital inflows.”
utility company that’s very useful.” And of course, institutional and retail investors are on the
The underlying index measures hurricane size and maximum lookout for uncorrelated assets. “There are opportunities to
wind speed. Contracts trade at $100 for each 0.1 points on the create an index in the catastrophe markets, just as UBS has done in
index. A relatively small hurricane with a 60-mile radius and 74 the weather markets,” says Kendall Johnson of TFS Energy.
32 energy risk energyrisk.com

34. Solutions
Getting a grip on climate risk
A new index lets investors express their views on how fast the planet is warming
cities – including New York, Chicago,
Atlanta, and Las Vegas – that are most
actively traded on the CME’s weather
derivatives exchange. Between May 2 and
September 3 this year, an excess temper-
ature of 0.68ºF on these contracts caused
the index to climb by almost 35%. This
performance showed minimal correlation
with any other investible asset class, a fact
that could make the climate an interesting
candidate for inclusion in otherwise tra-
ditional portfolios. Access to the index
would be via structured products, perhaps
in combination with other types of asset.
More cities could potentially be included
in the index. The CME currently trades
weather derivative contracts for 18 US and
nine European cities, as well as six Cana-
dian and two Japanese locations. To be
eligible for inclusion in the GWI, however,
the volume of futures traded for any given
city must represent 1% or more of the
total weather derivatives contracts traded
A broader swathe of investors can now give climate derivatives a whirl on the CME. Provided they meet this con-
dition, European and Asian cities are likely
to be included in the GWI over the me-
Weather derivatives have been traded Bank to come up with the world’s first dium term. A UBS-GWI governance com-
for the best part of a decade. In theory, ski index that tracks temperatures on a mittee will meet annually to determine
resorts could use them to hedge against national and regional rather than a local the composition and the weighting of the
warm winters or brewers to protect them- basis. Launched in April this year, the UBS UGWI index and its family of sub-indices,
selves against cool summers. In practice, Global Warming Index (UBS-GWI) is a trad- which currently covers four US regions: the
though, most users are in the energy sec- able benchmark for global investments in Northeast, Midwest, West and South.
tor. The Chicago Mercantile Exchange the weather derivatives market. It provides Although there has been a dramatic in-
(CME) established a weather derivatives a rational and simple way to obtain finan- crease in weather derivatives volumes over
exchange for temperature contracts ref- cial exposure to large-scale trends in the the course of the last few years, traded
erenced to certain US cities in September climate. The index should also prove useful products using weather remain inacces-
1999, later adding European and Asian to industries that need to hedge against sible to the vast majority of the financial
references. More recently, the CME has damaging climatic trends. Potential users community. Used mainly as a hedging in-
added contracts on snowfall, frost and could include many branches of agricul- strument by energy, insurance and com-
hurricanes. These innovations helped lift ture, tourism and construction. modity professionals, weather derivatives
total CME turnover in weather contracts remain largely untouched as an asset
to some $45 billion in 2005 –2006. This How it works class in their own right. UBS’s new Global
success has attracted attention elsewhere. The UBS-GWI is based on existing CME Warming Index could change that by pro-
In mid-2006, China’s Dalian Commodities weather futures contracts that settle on viding a simpler way for a broader range
Exchange announced that it planned to the difference between the average daily of institutional and private investors to
start trading weather futures, with the aim temperature and a base temperature of gain financial exposure to global tempera-
of helping Chinese farmers hedge their 65ºF. These are Heating Degree Day (HDD) ture trends.
exposure to bad weather. and Cooling Degree Day (CDD) contracts,
Weather, though, is not climate. As cli- so-called because they measure how far it
Ilija Murisic UBS Investment Bank,
matologists like to say, weather is what is necessary to heat or cool buildings in the Non-standard derivative products
you get while climate is what you expect. prevailing weather conditions. At present, ilija.murisic@ubs.com
This insight prompted UBS Investment the index comprises contracts on the 15 US
14 UBS News for Banks / Winter 2007

35. Solutions
Inconvenient truth: now you can hedge against it with the UBS Greenhouse Index
Turning up the heat
New index broadens the choices for investors concerned with
climate change
Unless you are a dairy farmer in Green- If it chooses, this clientele can now focus four-fifths of the combined emissions in-
land, climate change is an inconvenient even more selectively on the human- dex by value, reflecting its greater underly-
truth. For most such inconveniences, induced element in climate change. The ing market volumes. As index components
though, there is a convenient tool for recently launched UBS Greenhouse Index are weighted according to the volume of
hedging their effects. Climate change was (UBS-GHI) is a play on both temperature underlying transactions, new weather con-
the exception until April last year, when trends and, indirectly, on the amount of tracts or carbon reduction schemes could
UBS launched its Global Warming Index carbon dioxide in the air, an important be added to the GHI in future, if justified
(UBS-GWI). Rolling into a single instrument cause of global warming. Half the index by their popularity.
a selection of intensively traded weather by value is based on the existing Global As the existence and pricing of carbon
derivatives, the index offers investors a Warming Index, while the other half reduction schemes depend wholly on
new and handy way of expressing views tracks futures contracts on two princi- human agency, the GHI is a more complex
on regional or national climate trends in pal markets for carbon emissions, the EU instrument than its predecessor. It should
the US. (See News for Banks, Winter 2007 Emission Trading Scheme (40% of the appeal to institutional investors looking for
edition for more details.) index) and the Kyoto Clean Development additional portfolio diversification, reckon
This invitation was taken up with enthu- Mechanism (10%). Thus the index delivers the product’s designers within UBS Invest-
siasm. Since inception, the Global Warm- exposure to temperatures across a selec- ment Bank’s hybrid derivatives trading
ing Index has attracted some $100 million tion of US cities, as well as prices for unit. Other users could include businesses
in contracts. Even more significantly, it has carbon dioxide in the EU and for carbon exposed to the risk of adverse climate
built a new user base for weather deriv- dioxide reductions sold by developing change and those that need to hedge
atives. While traditional weather futures nations to developed ones. against the risk of legislation designed to
tend to be patronized mainly by energy For investors preferring to concen- curb carbon dioxide emissions. You could
professionals and a few specialized hedge trate solely on greenhouse gas emissions, even sell the index short to hedge against
funds, the GWI has pulled in insurers, pen- a family of sub-indices is available that the unlikely risk of global warming going
sion funds, and even retail investors. GWI track either the European emissions trad- into reverse.
investors have been rewarded by a 53% ing scheme or the Kyoto Clean Develop-
rate of return since inception (as at mid- ment Mechanism or both in combination.
Ilija Murisic UBS Investment Bank,
February), as well as minimal correlation As in the emissions part of the parent in- Hybrid Derivatives Trading
with other asset classes. dex, the European scheme accounts for ilija.murisic@ubs.com
UBS News for Banks / Summer 2008 19

36. Solutions
The sea may be calm but the freight rates are volatile
Blue Sea thinking
A new index on sea-freight derivatives helps investors tap into the China story
In the same week that UBS launched on time. The upshot is a rising trend in also incorporates a “Port Congestion Fac-
its Blue Sea index on freight derivatives, freight rates, coupled with spectacular vol- tor” that takes into account the effect on
the 203,512-tonne bulk carrier China atility; the benchmark Baltic Exchange sea freight derivative prices of loading or un-
Steel Team was booked to carry iron ore freight index for dry commodities sagged loading delays in more than 60 iron ore
from Brazil to China. At a record-break- by more than a third between November and coal ports worldwide.
ing $303,000 per day, the freight rate last year and mid-January 2008 on fears The index is aimed primarily at investors
was more than three times higher than of a US recession, although it has since who are interested in freight as a generic
the ship’s last fixture, just one month pre- bounced back. asset class. In addition, shipowners and
viously. China Steel Team is one of fewer That volatility, of course, has already charterers could use the index to hedge
than 600 Capesize bulk carriers in the attracted banks, hedge funds, and other their total exposure to freight rates. For
world. And as the name of this particu- financial institutions. So far, would-be this purpose, sub-indices are also available.
lar one suggests, China’s prodigious appe- investors have looked to the existing mar- These are based on the three categories of
tite for raw materials is keeping all of them kets for sea-freight derivatives, which are bulk carriers that comprise the main index,
busy. That’s not surprising, when you con- based mainly on futures and forwards on namely the Capesize giants and the hand-
sider that Baosteel, China’s leading steel the principal reference indices. What was ier-sized Panamax and Supramax types.
producer, needs 150 ship-loads of ore lacking, however, was a packaged instru- It’s too early to say which types of
every year to feed its blast furnaces. ment that offered a balanced exposure to investor will make the most intensive use
Statistics like these explain why sea a representative spectrum of the dry-bulk of the new index. But Blue Sea has cer-
freight rates are rocketing, particularly for freight market. It was this gap that UBS tainly captured the attention of industry
dry bulk cargoes such as iron ore or coal. sought to fill when it launched its Blue Sea experts. Lloyds List, the longest-standing
According to Simpson Spence & Young, a Index on May 22. daily newspaper for the maritime industry,
consultancy, average dry bulk freight rates commented as follows: “This new UBS
reached almost $220,000 per day in May, Congestion factor initiative deserves to be watched as it may
up from $80,000 or below in January UBS Blue Sea is the first fully integrated in- introduce a new level of sophistication to
and a previous long-term average of dex to be benchmarked on the most ac- the freight derivatives market by opening
$15,000 – $20,000. Capacity shortage is tively traded dry-bulk forward freight it up to investors who are not necessarily
responsible for part of this squeeze but agreements. FFAs are non-standardized freight professionals. The Blue Sea Index is
a lack of tonnage is not the whole story. over-the-counter forward contracts based indeed blue sky thinking.”
Even if the 185 or so Capesizers on order on one of several underlying freight indi-
could be delivered tomorrow, ports and ces. They are agreed between two parties
Ilija Murisic
cargo terminals are too choked with ship- for a specific route, for a specific delivery UBS Investment Bank, Hybrid Derivatives Trading
ping to allow them to load and unload rate and a specific vessel type. The index ilija.murisic@ubs.com
UBS News for Banks / Autumn 2008 15

38. !""""""""""""""""""""""""""""""""""""
!!!!!!!!!!!!!!!

47. WEATHER Derivatives
Weather Derivatives
It was picked up by energy companies who found
that fluctuations in weather were hampering their
ability to deliver steady earnings to investors. Peter
Brewer, chief investment officer of Cumulus Funds,
says: “It came down to people would use gas if it
was cold to heat things up and electricity if it was
hot to cool things down. The contract would pay
money out if the temperature changed.”
Insurance companies then became involved, who
saw it as a means to move risk around. In 1999, the
Chicago Mercantile Exchange (CME) began to list
temperature futures. These were vanilla contracts
based on the temperature in certain cities on certain
days. Brewer says that this was an attempt to turn
what had been an over-the-counter market into an
exchange-traded one, but it generated little interest
from any of the market participants at the time.
The implosion of Enron in late 2001 caused consid-
erable dislocation in this nascent market. It had been
the biggest player and the market was left with a dis-
parate bunch of investors and traders, which includ-
ed some insurers, some banks and some energy
companies. But Enron employees started to move
into the insurance groups and banks and resume
trading there.
Brewer says: “It really started to happen post-
Enron. There was more focus on counterparty risk.
The Chicago Mercantile Exchange removed that
credit risk and began to pick up a lot more business.
Cherry Reynard reports on the By 2002, it had a 90% share of trading activity in
latest hot product to change the weather derivatives.”
The weather derivatives market now splits neatly
derivative landscape into two main areas: There is the secondary market,
According to the Chicago Mercantile Exchange, which trades on the CME and then there is the more
weather has an impact on revenues for around 30% esoteric off-exchange market, which allows for more
of the US economy. For many companies, this is structured deals. According to statistics from the
higher than foreign exchange risk or other types of Weather Risk Management Association (WRMA),
risk that are widely hedged. With the impact of cli- around 730,087 derivatives contracts were traded
mate change making weather conditions more from April 06 to March 07. This was down on the
unpredictable, the business risk from weather looks previous year when hurricanes Katrina and Rita
set to rise. Yet, the majority of companies do not increased the appeal of hedging weather risk and
hedge against the weather and weather derivatives over one million contracts were traded. Hurricane
remain a young and relatively immature market. Is Katrina, in particular, proved one of the most cost-
this likely to change as climate change becomes ly in US history, with estimates of damages around
more potent? USD65bn.
The first widely-known weather derivatives deal was Volumes on weather conditions in the US were
completed between fallen energy behemoth Enron largely stable, while European contracts declined.
and Koch Energy in 1997. It was structured around However, the WMRA said that it was seeing rapid
temperature conditions: Like a spread betting deal, underlying growth in the weather business in other
Enron would pay Koch $10,000 for every degree the regions of the world, notably India, which are yet to
temperature fell below a set level, while Koch would be captured in the survey. The WRMA says that
pay the same for every degree above it. early indications for the 2007/2008 survey period
34 ALTERNATIVES

48. WEATHER Derivatives
suggest that the number of contracts traded will be more in the market. It is difficult to quantify the
nearer the 2005/2006 figures. If catastrophic weath- exact size of the market as there is no centralised
er conditions continue to be a predictor of trading data point, but it is thought that this market is now
volumes (as they have been in the past), then much larger than the exchange-traded market.
2008/2009 is likely to be even stronger, encompass- Catastrophe, or "cat" bonds are also a growing
ing the earthquake in China, cyclone in Burma and area. These are issued by insurance companies and
further hurricanes in the mid-West of the US. designed to cover particular risks. Investors will buy
For the exchange-traded market on the CME, the on the assumption that an event won't happen. If
main volume is in contracts on heating degree days the event happens, the investors lose their money
(HDD) and cooling degree days (CDD) on 18 cities and the insurance company makes enough money to
around the world. Temperature contracts accounted cover a proportion of the money it has to pay out to
for volumes of USD18.9bn in 2006/2007. Although its clients. These bonds are also being picked up by
much of the trading is in US cities, CME offers hedge funds in a blurring of the lines between insur-
futures on temperatures in Amsterdam, Barcelona, ers and weather derivatives investors. Traditional
Berlin, London, Madrid, Paris, Rome and 'catastrophic' events have been seen as the domain of
Stockholm. These are well-traded, liquid contracts the insurers alone.
and are mostly traded by energy companies, funds The corporate users of these products are dis-
(including hedge funds) and insurance companies. parate. For example, the CME launched snowfall
The presence of large energy companies means futures and hurricane futures primarily to help state
most arbitrage opportunities quickly disappear. governments manage their budgets. In addition to
The CME has tried to expand its range recently, energy companies, beverage producers are subject to
finding that demand for weather hedging goes the vagaries of the weather - Britvic, for example,
beyond temperature. As such, it has introduced made several references to its vulnerability to weath-
products focused on frost, snowfall, rainfall and er conditions in its recent results statement.
even a hurricane future. However, trading in these Construction projects can be influenced by the
areas remains relatively limited with rain and wind weather as can ski resorts and other holiday groups.
contracts attracting volumes of just USD142 million Retailers are often affected by high rainfall and poor
and USD36 million respectively in 2006/2007. conditions as people don't tend to go out shopping.
The key problem for the CME in developing new On the other hand, WH Smith benefited from last
products remains access to quality data. Eric Gisiger year's terrible weather because people stayed inside
a member of the investment committee of Man and read books.
ECO says that few companies actually understand San Francisco-based WeatherBill has just pub-
the impact the weather has on their bottom line. He lished a study identifying the relationship between
adds: “They know they might get depressed results weather conditions and flight disruptions. It showed
due to poor weather conditions , but have less of that 14% of the 21 million flights evaluated in the
an idea how much is attributable to the weather and study were delayed or cancelled due to
therefore how much they need to hedge. Available weather. More than 25% of all flights “This market is still
standardised weather contracts such as the ones
traded on the CME could be used but usually have a
studied were cancelled or delayed of
which 55% of those disruptions (3 mil-
very immature and
basis risk, in other words do not perfectly hedge the lion flights) were weather-related. Thestill very opaque,
underlying risk.”
He believes that although these contracts are use-
survey showed some airports such as San
Francisco, Reno and Chicago's O'Hare
that's why hedge
ful, they can only ever represent standardised suffered disproportionately from weath-funds like it”
hedges. There is therefore a basis risk. The weather er-related delays.
in central London is not necessarily the same as in These corporate will use the basic con-
Heathrow and therefore the standard products do tracts available to them on the CME and Stephen Doherty,
not always reflect the exact market risk. also structure their own deals if they
The off-exchange weather derivatives are only need more tailored, specific hedging.
chief executive officer
marginally captured by the WRMA statistics. They need to make sure that this type of at Speedwell Weather
Examples of this type of contract could be whether hedging is cheaper than insurance.
it is going to rain at a sporting event or whether it Doherty says that some of the most complex deals
will snow in Meribel this season. Stephen Doherty, are now within agriculture. This has felt the early
chief executive officer at Speedwell Weather, says: effects of climate change most significantly with
“These more exotic structures will be based on the crop destroyed by poor weather conditions. He adds:
fair value for the trade plus a profit margin for tak- “There has been an explosion in this area. Weather
ing the risk. These products are unlikely to trade conditions affect crops - including rain and temper-
thereafter.” ature. Timing is also important. You are seeing some
These tend to be smaller volume trades, but there are exotic weather structures in this area.”
ALTERNATIVES MAGAZINE 35

49. WEATHER Derivatives
Investment buyers of weather derivatives will tend ingful performance statistics, but Brewer says that it
to be standard investors such as pension funds and has been run on a formal 'paper trading' basis for 16
asset managers looking for a non-correlated asset months and delivered annualised returns of over
class. This is where UBS has seen most demand com- 15% to end-December despite considerable volatility.
ing for its Global Warming index (see box-out). It targets 15-20% returns on 10% volatility.
Gisiger says that hedge funds active in the space also The Nimbus fund, based in Bermuda and run by
look at the non-exchange traded , insurance market. Nephila has also proved popular. The Nephila spider
He says: “This market is still very premature and can apparently predict hurricanes, spinning its web
opaque, a key reason why hedge funds like it. The close to the ground when a hurricane is approaching
bespoke insurance market is bigger and more attrac- and high up in the shrubs and trees when the weath-
tive in terms of potential margins to be earned but er is nice. The group has recently signed an agreement
also requires a specific skill set rarely available. to provide risk capacity and collateral to WeatherBill
Market participants assume that a lot of the hedge to support weather contracts sold to customers.
fund money goes into the bespoke deals, though There are also a number of more mainstream
there are hedge funds actively trading through CME weather-related investments launched in the retail
contracts. ” market such as the Schroders Climate Change fund
There are a number of specific weather funds and the Virgin Climate Change fund. This demon-
investing in the derivatives market. Brewer runs the strates that demand is there among retail investors for
Cumulus Climate fund, which launched in February, this type of product, but so far these have been
and has a technical, quantitative-driven approach. entirely equity-based.
The fund is a long-short equity fund which seeks to So how big is the weather derivatives market likely
profit from the financial impacts of climate change. to become? Doherty says: “The Enron idea that
It has not been running long enough to deliver mean- weather derivatives will be as big as FX is not realis-
tic. Weather risk is important, but the market will
The UBS Global Warming index
grow quietly. It will be resilient but unexciting. There
The UBS Global Warming index (UBS-GWI) is the only index that currently is a flexible and deep pool of capital and so far the
exists for the weather derivatives markets.The index grew out of demand ability of the market to adapt and step up to the plate
from multi-asset clients for new uncorrelated assets. Ilija Murisic, Executive has been surprising.” Hel believes there is ample
Director, Hybrid Derivatives Trading at UBS says: “In 2007, the equity and
capacity in the market and it won't be constrained by
commodity markets had rallied and investors were looking for asset classes
a lack of capital.
that were truly uncorrelated.We started to look at weather derivatives and
Gisiger says that at the moment corporate buyers
thought they were a very interesting market.There was empirically no corre-
lation with equities.” are restricted by the assumption that weather is sim-
The UBS-GWI was launched in May last year and is constructed using the ply a hazard of day-to-day business and therefore
Heating Degree Day (HDD) and Cooling Degree Day (CDD) weather does not need to be hedged in the same way as other
futures contracts traded on the CME.The index is currently composed of risks, though he believes more companies are becom-
weather futures contracts on 15 U.S. cities.To be eligible for inclusion, the ing aware of the options for hedging their weather
volume of futures traded for any given city must represent 1% or more of exposures.
the total weather derivatives contracts traded on the CME. At the moment, Brewer concludes: “A lot of people said in the early
futures on New York weather form the largest part of the index at 31%. days that this could be the biggest business on the
Cities from Europe and Asia are expected to become part of the index in the planet. That's not something we would argue. This is
medium term. a specialist market for companies concerned about
The UBS-GWI Governance committee meets annually in September to revis- the weather. It will grow, but we are not about to see
it the weightings of the index and its sub-indices family (currently composed a doubling of volumes every year. That said, more
of four US regions: Northeast, Midwest,West and South). companies are becoming aware of the possibilities
Since launching this index, UBS has moved into similar areas, launching carbon and we are seeing more catastrophic weather condi-
trading, energy, commodities and freight indices. Murisic believes there is tions.”
good potential growth in these markets, pointing out that the weather deriva-
For the market to take off, there would have to be
tives market has grown from $2.2bn in 2004 to around $40bn in 2007.
increased shareholder pressure on corporates to
Murisic says that although the underlying instruments are complex, the index
hedge out weather risk, plus an increased number of
itself is designed to be very simply and trade like the S&P index. Investors
don't need to look at seasonal variations.The index performance has moved investment buyers seeking uncorrelated returns. As
from around 100 at launch to around 250 today. yet, there is little shareholder pressure, but corporate
Investors have been varied. Murisic says: “We have had a lot of interest from are becoming aware of the potential of the weather
insurance companies. Many of our investors come from Europe, particularly derivatives market and a growing number of buyers
Scandinavia and from Asia. Hedge funds have not been a big buyer, but there are looking for new, alternative asset classes to hedge
has been a lot of interest from wealthy private individuals. Asset managers out risk. Increased unpredictability of weather
and pension funds use the asset class to diversify - they have an allocation to conditions is also likely to stimulate demand. The
alternatives and they put some of it into weather.” In general, he believes that market is unlikely to see the sort of bullish partici-
interest has not come from specialist weather funds and weather investors, pants it had in Enron, but should see steady growth
but more from normal investors looking for diversification. over the next few years. A
36 ALTERNATIVES

54. FINANCE
Changing tack
by
MICHAEL HOLLMANN, GERMANY CORRESPONDENT
Enticing fresh
liquidity
ROCKETING refinancing costs have put the
banks on alert. Liquidity and risk premiums
will remain an issue for shipping clients
beyond the sub-prime crisis.
Finance used to be easy to obtain with net
interest margins hitting record lows, not
least for German shipowners who have some
of the largest banks in the maritime world
New shipping indices will allow institutions and
right on their doorstep. But that was before
summer 2007, when the US sub-prime sector
individuals to bet large, Barry Parker reports. They
Photo: UBS
melted down, sending shockwaves through
the world of Western finance and forcing
could also provide owners with more hedging flexibility
interbank and syndication markets to a halt.
More than $900Bn has been slashed
T
off balance sheets worldwide, the IMF has
estimated. Many shipowners were caught
off guard and cruelly reminded of the perils
of not sealing finance at the outset of a
newbuilding order. Financing costs went up
overnight as liquidity dried up because banks
lost trust in each other, thwarting earlier
project calculations and causing an outcry
among German KG houses and shipowners.
But the banks were perfectly right in
doing so, argued Hans-Joachim Weinberger,
‘[Clients]
head of ship finance at federal state bank wanted to
Nord LB. It used to be common practice for
owners to file an application for funding have a simple
at the outset of a newbuilding project or a way to access
planned acquisition of a second-hand vessel
to get their bearings on prospective of loan the market’
costs. But Weinberger pointed out: “Many of
Ilija Murisic (above)
them refrained from signing a standby credit,
so there was never a real commitment.”
Given plentiful debt capital and availabil-
ity of cheap loans at any time, owners were
keen to avoid paying the customary commis-
sion charged for a standby loan facility. “KG
houses, shipyards and ship finance arrangers
used the savings to bolster their own profits,”
he said. “Some of them saved on commission
payments over four years.”
What used to be a cost edge has turned
into a disadvantage, which is jeopardising
new KG ship projects, some of which are
based on very optimistic assumptions.
High ship prices and rising operating costs
Exploiting those ‘arbs’ and freight and freight on board. With
FFA markets blossoming, JP Morgan
shipping analyst Jon Chappell has pub-
are already enough risk; if loan costs go out of TRADERS seek to profit from arbitrage Freight traders exploit such differen- lished research guiding his clients
control as well, financial safety margins can opportunities, exploiting a difference tials when lining up timecharter toward opportunities, given that FFA
easily be wiped out. Shipowners will not be between two items that should be equivalent of voyage freight against the rates exceed rates implied in publicly
able to escape rising interest margins, even closely priced. The imperfect informa- actual cost of a timecharter ship on that traded share prices. “In the tankers, to
if they continue to apply delaying tactics, tion of shipping markets presents route, or when chartering a ship because exploit the arbs, I recommended buy-
Weinberger warned. frequent arb openings. of a wider gap between cost, insurance ing OSG shares,” he said.
16 Fairplay 12 June 2008 www.fairplay.co.uk

55. Panorama – 17-Jul-08