June 9, 2013

Hurricane (Weather) Derivatives: They Are Already The Future!!

Hurricane 'Fran', 1996


Hurricanes are the high impact low probability events lurking in the extreme ends of a distribution. Although, they occur on a regular basis with a yearly cycle and past data is plentiful (see Chart 1 below), predicting the expected number and impact of hurricanes remains a challenge. It is indeed impossible to predict a hurricane damage. As showed in Chart 2, there is no trend at all (hurricane damages were adjusted for inflation, wealth growth and population). Financial markets have been attempting to find a way to allocate this risk with the help of hurricane derivatives products.

Chart 1 

Chart 2

Hurricanes are complex and chaotic systems. It is difficult to predict their paths even after their formation. Hurricanes developing over the Atlantic usually start out as a tropical wave from the west coast of Africa and if the circumstances are ideal (e.g. high sea surface temperature and vorticity) the system starts to develop. Over the vast surface of hot water the system gathers strength, organizes and after making landfall it leaves destruction in its wake. The joined effect of strong wind, heavy rain fall and costal surge following the hurricane are responsible for death and damage in the magnitude of dollar billion. On the other hand hurricanes have an important role in the polar heat transfer. The financial impact of these storms is critical for individuals and for big corporations as well: a family can lose its home, a cruise ship company can lose its fleet and Electricity Company may have to change the entire infrastructure due to a great storm.
The most vulnerable regions are the regions on east coast of the United States. There are two distinct trends that make the landfall of a hurricane more damaging. The first trend is in the population trend. An increasing amount of people chose to live on the coastal regions of the United States. The surge in populations has brought increasing wealth, and resulted in higher wealth at risk of hurricane landfall. The second trend is that over half of the US industry is found at the coastal regions. 

What are Hurricane Derivatives?

Hurricane Derivatives are contracts that provide the buyer financial protection against the negative effects of a hurricane. Contracts were first introduced at the Chicago Mercantile Exchange in 2007 and are now mainly traded on the over-the-counter market. The counterpart is usually a financial institution such as insurance and reinsurance companies, hedge funds, energy and utility companies, pension funds.
The pay-off of the contract varies according to the occurrence of certain conditions such as the landfall of the hurricane in a specific geographical area, or the index (upon which the contract is based, called CHI) reaching a certain maximum amount. If conditions are met, the pay-off is computed according to the number of contracts the buyer hold and the amount of the CME Hurricane Index (CHI) at the time the conditions are met. The contract is quoted on CHI points, with tick size of 0.1 point. The total number of contracts outstanding (open interest) was 2,700 in 2011 (an increase of 68.75% compared to the previous year) with trading volume of 4,000. 


Hurricane derivatives are among the least liquid of all weather products. Open interest and trading volume are very low compared to other derivatives products. The reasons for the lack of liquidity must be researched in the characteristic seasonality of the hurricane phenomena: liquidity increases as the storm begins to develop and decreases as the probability/frequency of an event decreases. Consequently, most of the trades happen at the beginning of the hurricane season with trading volume decreasing as the season comes to an end. Furthermore, institutional buyers use hurricane derivatives as substitutes for insurance, as they are highly customizable, further dragging down liquidity. Individuals can in fact chose to customize their contract according to the name of the storm, landfall location, location boundaries (once these are  crossed, payment triggers) the CHI threshold beyond which the  payment triggers, etc. Last but not least, the minimum contract size makes these contracts highly attractive to retail investors, although they haven't traded much these contracts so far. 

The underlying is the CME Hurricane Index (CHI). The index is driven by two factors: maximum sustained winds (V, in mph) and the radius of hurricane-force winds (R). The formula to compute CHI at a certain point in time is:

With V0 = 74 statute miles per hour and R0 = 60 statute miles set as threshold. The NOAA National Hurricane Center declares that a tropical cyclone turn into a hurricane (in the Atlantic and East Pacific basins) if these two values are reached. If V is less than 74 mph, then CHI is set equal to zero. A storm with sustained winds of 80 miles per hour and a radius of 30 miles scored 2.14 on the scale. To put this into perspective, 20 hours before landfall Katrina had scored 27 on the scale (see graph below). The track of the storm is closely monitored and in case it makes landfall, the CHI index number is multiplied by the notional amount of each contract ($1000, in case of standard futures and options)

Products offered:

The products offered by the Chicago Mercantile Exchange are mainly four: Hurricane futures and options, Hurricane Seasonal futures and options, Hurricane Seasonal Maximum futures and options and Hurricane Index Binary Options. Contract size for the Hurricane futures and options is rather big, a 0.1 point increase in the CHI has a ticket value of $1000. As an example, Katrina 30 hours before landfall had a CHI of 6 (see graph above). 14, 5 hours later. In case of a future contract, that would trigger an immediate payment of $800,000 (800 CHI points times $1000). Since futures contract always involve cash-flow risk it is advisable to think before entering into the contract. Hurricane Seasonal futures and options have a smaller ticket value (only $100) but they are traded all year long and are expressed in terms of the accumulated CHI for all hurricanes that occur within a specific location. Hurricane Seasonal Maximum futures and options don't differ much from the previous ones: contracts are designed to trigger payment depending on the largest (in terms of CHI) hurricane to make landfall within a specific location within a year. Finally, Hurricane Index Binary Options include all the features of the contracts mentioned above but have more flexibility. The payout would trigger if the contract exceeds the predetermined strike price. In this case the buyer receives a fixed amount of $10,000. The strike price of the contract is determined by the CHI level (10, 11, 12, etc.). If a storm hits a certain level while in a specific location the contract triggers a payout. 

1) On the Hunt for the Birth of a Hurricane - AIRS, NASA
2) Storm Surge Overview - National Weather Service 
3) The Deadliest, Costliest, And Most Intense US Tropical Cyclones From 1851 To 2004 (And Other Frequently Requested Hurricane Facts) Blake, Rappaport, Jarrell, Landsea (2005) 


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