"Academic Rains on Weather/Return Correlation Parade"
Wessel Marquering, Ph.D., CAIA
Thu., May 29 - AllAboutAlpha.com
"Academic Rains on Weather/Return Correlation Parade", posted May 29 on AllAboutAlpha.com
Wessel Marquering, Ph.D., CAIA
Talergroup
As readers of this website are no doubt aware, weather derivatives trading is taking off - with trading volumes going through the roof and more hedge funds venturing into this space. Basically, a weather derivative is a financial product in which two parties agree to exchange cash flows determined by reference to a weather index. The reference indices include temperature, rainfall, wind speed, humidity, snowfall, to name a few, but the most heavily traded contracts are based on temperature indices.
On the one hand, weather derivatives can be used to manage risk, by insuring for example farmers against a bad crop, as an insurance against bad weather on holidays, by decreasing the exposure to temperature-related risk factors, etc. On the other hand, they have become a relatively new way to generate alpha.
These alpha opportunities arise because weather derivatives are difficult to price. And since weather patterns are not random, the Black-Scholes option model is not entirely appropriate. Some hedge funds actually hire meteorologists and run highly quantitative models to forecast the weather in an attempt to identify "bargain" contracts. Since the weather is uncorrelated to, for example, sub-prime, Iraq war, etc., they are a great addition to investors' portfolios.