Commodity Analysis

It’s time India launched weather futures

Lokeshwarri SK | Updated on May 12, 2018 Published on May 12, 2018

Instruments to hedge risks posed by weather benefit farmers and businesses

Managing risk has become the buzzword in India in recent times. But it is surprising that instruments to hedge risks posed by weather are not present in the country, especially given the agrarian tilt in its society and the large impact weather has on various industries, including consumer durables, FMCG, agri commodities and inputs, and cement and construction.

Futures and options based on weather have been traded since 1999, when the Chicago Mercantile Exchange (CME) allowed trading of these products. Now, derivatives that track temperature, rainfall, snowfall and even hurricanes are available for trading in exchanges worldwide.

In India, while indices to track rainfall are available, the regulator is yet to give permission to exchanges to launch future or option contracts based on these. With the regulator going about the task of improving the commodity derivative market in a phased manner, it is expected that weather derivatives could see the light of the day quite soon in India as well.

The obvious beneficiaries from these instruments are farmers, who can, through such contracts, hedge the risks arising from monsoon failure or crop damage due to excessive heat or cold.

Air-conditioner and air-cooler companies that sell more of their products when the temperature is soaring, and makers of soft-drinks and ice-creams that do brisk sales in summer months can hedge against a relatively milder summer through temperature-based contracts.

Similarly, real-estate development and construction activities come to a standstill when there is excessive rain. These companies can use rainfall-based contracts to hedge risk.

CME contracts

It would be good to observe the manner in which global contracts are constructed to see if they can be adapted for the Indian market. CME’s temperature-based products are the most popular weather-based derivatives globally. The exchange offers Heating Degree Day (HDD) and Cooling Degree Day (CDD) contracts for various regions across the US and Europe.

The HDD and CDD contracts are based on degree days that are calculated based on the deviation of a day’s average temperature from 65 degrees Fahrenheit in the US or 18 degrees Celsius outside the US. The average daily temperature is the average of the day’s maximum and minimum temperature.

HDD is arrived by deducting a day’s average temperature from 65 degrees. For instance, if the average daily temperature is 30 degrees, the HDD value will be 35 (65-30). If the day’s temperature is higher than 65, the value is considered to be zero. The index value will thus be higher when temperatures are cooler. Oil and gas companies, and those manufacturing heating equipment use this contract to hedge risk from a milder winter affecting their business. They could take short positions in these contracts that can turn profitable when temperatures are not as cold as expected.

The CDD contracts are used by businesses that thrive on rising temperatures. To derive this value, 65 has to be deducted from the day’s average temperature. So higher the value of the index, more the need for air conditioners, ice-creams, etc.

Another variation of the temperature contracts is the Cumulative Average Temperature (CAT) Index that tracks average daily temperatures for a month in a given city; the cumulative number is used to calculate the contract value. Each CME European CAT Index is the total of daily average temperatures over a calendar month or season for a particular city.

Adapting for India

Calculating a temperature index based on CME’s HDD and CDD models does not appear too difficult for India.

Since Indian summers offer more business opportunities, HDD indices can initially be calculated for the four metros — New Delhi, Mumbai, Kolkata and Chennai. The base temperature can vary slightly between 30 and 35 degrees for each of these cities.

Businesses in these regions can used the appropriate index to hedge. MCX India has three rainfall indices — raindex for Mumbai, Jaipur and Indore.

The index is calculated using data from the India Meteorological Department. These indices are mainly designed to reflect the rainfall during the monsoon season. The cumulative rainfall for the period is shown as a surplus or deficit against normal historical rainfall. The normal index values for Mumbai, Indore and Jaipur are 1,950, 950 and 350, respectively. The raindex is constructed in a way that it reflects the net surplus/deficit in rainfall towards the end of the season.

While this is a good first step, similar indices need to be constructed for other regions in the country, too, with the help of IMD data. Since the raindex captures rainfall during the South-West monsoon alone, similar indices are also required to capture rains during the North-East monsoon .

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