Wednesday, July 23, 2008

Use 'weather derivatives' to weather droughts

(Interview by D. Murali and Kumar Shankar Roy, Hindu Businessline)

Chennai: With drought looming large over 14 meteorological sub-divisions, spare a thought for the planted crops that are in grave danger. For the farmers in Maharashtra, Andhra Pradesh, Karnataka and Kerala this monsoon has brought everything except the much-needed moisture. "Come rainy season and nearly 59 per cent of the Indian population, the people dependent on agriculture, keep their fingers crossed. Some pray to the rain God to ensure that it does not pour so hard that their crops get destroyed. On the other hand, in some villages, the farmers tie two frogs to a pole and get them married, a superstition which is supposed to bring good rainfall," quips Dr Nupur Pavan Bang, Faculty Member at ICFAI Business School (Hyderabad).

Superstitions apart, the seriousness of weather cannot be over-emphasized. "When livelihoods are dependent on rainfall, it is only fair that people will go to any extent to make sure that their farms get adequate amounts of rains...the farmers and various other businesses in the US have been using the weather derivatives since 1997, to mitigate risks due to adverse weather conditions," Dr Bang told Business Line. Weather derivatives, what are those? These derivative contracts are being used successfully by farmers, theme parks, ski resorts, ice-cream manufacturers, energy and utilities companies etc. since over a decade now. Read the short Q&A on 'weather derivatives' with Dr Bang done over the email to gain new insights.

Does India's size often become a disadvantage?
India, as a country, faces great variations in weather conditions due to its diverse geographical structure. While some places are hit by flood, some other by drought, rising temperatures are scaling new peaks and chilling winters are breaking old records. Such diversity in weather conditions affects the business processes of many industries directly or indirectly. The aviation industry takes the toll of fog in northern India during winters; floods in many parts leave their impact not only on agriculture but also on the tourism industry.

Tell us about these weather derivatives.
Weather derivatives are unique in many ways. The primary being, there is no physical underlying asset. The underlying asset is the weather, that is, the temperature measured in degrees Celsius or Fahrenheit or rainfall measured in centimeters. On the Chicago Mercantile Exchange, the values of these contracts are calculated based on a weather index. The index can represent either a Heating Degree Day (HDD) or a Cooling Degree Day (CDD). A HDD is the difference between a baseline temperature and the average temperature for a day in winters. A CDD is the difference between the average temperature for a day and a baseline temperature in summers. The baseline temperature is fixed; it is 65 degrees Fahrenheit in the US and 18 degrees Celsius in Europe.

From where will the derivatives derive their value?
The value of the contract would be some multiple of the HDD or the CDD. The contract can be valued on a daily basis, or weekly, or fortnightly or monthly or for a season; depending on the contract specifications. In 2005, NCDEX launched a rain day index for the Mumbai city for informational purposes only.

Can you explain the utility of weather derivatives with an example?
Let's consider a farmer growing paddy in a village in Andhra Pradesh. He is worried because of the expectations of unusually low rainfall in the state this year. He usually produces 50 quintals of paddy in his farm. But this year, he thinks the production will drop to 40 quintals. The Minimum Support Price for paddy is Rs770/quintal. This means that the farmer fears losing Rs 7,700 this season due to poor rainfall.

If the farmer had access to weather derivatives, he could have bought or sold (depending on the future outlook for rainfall) rain day futures contracts today and entered into an equal but opposite contract at a later date, making a profit on the transaction, thus offsetting the losses due to low volumes produced.

What are the other uses of these weather derivatives?
Apart from applying weather derivative as a measure of hedging risk against adverse weather conditions it can also be used as the mode of trading in derivatives. The most advantageous factor of weather derivatives is the fact that they can't be manipulated by any means like insider trading as the raining patterns are natural and beyond the scope of humans.

Are there challenges to a widespread adoption of this type of financial instrument?
The key challenge is to educate the people about such contracts and their usage. The knowledge of derivatives in itself is limited to certain segments of the society, leave alone the weather derivatives. In spite of the challenges, it is time the Government speeded up the process of launching weather derivatives in India too.
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