Options,Futures,and Other Derivatives,5th edition ? 2002 by John C,Hull
29.1
Insurance,Weather,
and Energy Derivatives
Chapter 29
Options,Futures,and Other Derivatives,5th edition ? 2002 by John C,Hull
29.2
Weather Derivatives,Definitions
? 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)
Options,Futures,and Other Derivatives,5th edition ? 2002 by John C,Hull
29.3
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
Options,Futures,and Other Derivatives,5th edition ? 2002 by John C,Hull
29.4
Energy Derivatives
Main energy sources:
? Oil
? Gas
? Electricity
Options,Futures,and Other Derivatives,5th edition ? 2002 by John C,Hull
29.5
Oil Derivatives
? Virtually all 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,5th edition ? 2002 by John C,Hull
29.6
Natural Gas Derivatives
? 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,5th edition ? 2002 by John C,Hull
29.7
Electricity Derivatives
? Electricity is 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,5th edition ? 2002 by John C,Hull
29.8
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,5th edition ? 2002 by John C,Hull
29.9
How an Energy Producer
Hedges Risks
? Estimate a relationship of the form
Y=a+bP+cT+e
where Y is the monthly profit,P is the
average energy prices,T is
temperature,and e is an error term
? Take a position of –b in energy forwards
and –c in weather forwards.
Options,Futures,and Other Derivatives,5th edition ? 2002 by John C,Hull
29.10
Insurance Derivatives
? 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,5th edition ? 2002 by John C,Hull
29.11
Valuation Issues
? To a good approximation insurance,
weather,and energy prices can be
assumed to have zero systematic risk,
? This means that the,actuarial
approach” and the risk-neutral valuation
approach should give similar answers