Derivatives seem so mysterious and risky, it's hard to avoid the temptation to believe the rocket scientists who understand them are making a killing. They are, but that's not the whole story. The main goal of the instruments is to reduce volatility and that's something to desired.
Weather derivatives, introduced in 1999, offer companies an opportunity to make profitable derivatives trades to offset operating income disappointments caused by unexpectedly adverse climate. An example would be a gas company that sold short a Heating Degree Day contract - a trade that gains value as winters get milder - in advance of a winter that turns out to be exceptionally warm.
The downside is its tendency to diminish upside potential. Absent hedging, the same gas company could expect a nice windfall if the winter turns out unusually harsh and demand for energy used for space heating strengthens. Under this scenario, the Heating Degree Day short sale, based as it was on an opposite assumption, would produce a loss that would eat into the positive earnings surprise the company might otherwise have enjoyed.
Yet as long as companies cushion the downside when conditions move against them, investors would probably tolerate the times when they wind up forfeiting opportunities to benefit fully from exceptional upside strength.
Weather derivatives are still small potatoes. According to the Chicago Mercantile exchange, which trades these instruments, the notational value of contracts traded in the first nine months of 2005 was only $22 billion. But the pace of growth is very high (notational value in 2004 was just $2.2 billion), as one might expect in an embryonic-stage endeavor.
Observers believe other new categories of derivatives, such as those based properties, are also poised for brisk growth. However, weather may provide the easiest area of visibility for investors new to this sort of thing. .
When companies announce earnings in the weeks ahead, expect to see the usual amount of weather-induced volatility. But with weather derivatives evolving rapidly, it may be productive to start now envisioning how CFOs might hedge in the future. That can prepare you for the time, probably not too far down the road, when you may feel more comfortable including weather hedging, or the absence thereof, among factors that help you draw conclusions about companies and managements. You may even see portfolio managers of weather-exposed mutual or hedge funds trade weather derivatives to add hedging not supplied by the companies themselves.