By mid-June, Mumbai, India’s financial capital, should be under water. The southwest monsoon, the seasonal storm that provides most of this year’s water in South Asia, will bring heavy rains to the city. Street hawkers and builders will be cursed. Migrant workers living in slums may head to their villages to wait out the rains. Meanwhile, some businessmen and financiers will be patting their damp pockets full of rupees. On May 29, India’s National Commodities and Derivatives Exchange allowed traders to start placing financial bets on whether each monsoon month this year will be wetter or drier in Mumbai than the average for the past 30 years.
Weather derivatives, which are driven based on some clearly defined meteorological measurements, have been around in America since the mid-1990s. Earlier deregulation of US power utilities created a niche market in temperature derivatives, which companies could use to hedge their exposure to “cooling degree days,” when demand for air conditioning rose, or “heating degree days,” when households and businesses turned on heaters.
In contrast to traditional forms of insurance, insurance holders do not need to prove that they have suffered a loss themselves. Instead, derivative contracts are automatically activated when certain pre-agreed criteria are met. This could be the threshold temperature, wind speed or any other variable recorded at a particular location – usually an official weather station. This avoids long delays in getting money to where it is needed most. Last year, the Jamaican government received $150 million in compensation after Hurricane Melissa’s central pressure and storm path met criteria set out in “disaster bonds” issued by the Caribbean nation.
Precipitation derivatives are less common. The Chicago Mercantile Exchange, based in a city known for its bone-chilling winds, launched rainfall, snowfall and sleet derivatives in 2011, but canceled them in 2014 due to lack of demand. In the rich world, farmers, the most obvious beneficiaries of this protection, often rely on crop insurance and other more traditional tools. India’s hordes of smallholders are unlikely to flock to Mumbai’s monsoon derivatives (not least because they are concerned about the impact of the monsoon on their small plot of land somewhere in the Indo-Gangetic plain, not on the port city).
Instead, NCDEX expects allocation from large companies. Banks with agricultural loan portfolios may be one group of buyers. Hydropower companies, whose dams capture water from entire river basins, may be another example. The report notes that solar producers could become sellers. So can hedge funds.
Whoever enters into contracts from either party must be prepared to soak. Pricing weather derivatives is more difficult than pricing stock options or commodity futures. The financial mathematics used to price traditional derivatives doesn’t work because there are no underlying assets. Modellers must rely on weather forecasts. This is more difficult to achieve in rain, which is sensitive to small weather changes, than in heat. Meteorologists, trying to predict monsoon rainfall, encounter “bursts,” when clouds suddenly dump their load of rain in one place, and “fluctuations,” feedback between the ground and air that can lead to sudden changes in the timing and intensity of rain.
NCDEX may also have focused on the wrong weather-related risks initially. Temperature seems more relevant to India than rain. According to Pranjul Bhandari, of HSBC, tracking this indicator is now enough to predict food price inflation in India. Reservoir levels, vulnerable to evaporation in extreme heat, are more important than rainfall for farmers who use irrigation. In contrast to grains, which can be stored after a good monsoon like last year, perishable fruits and vegetables die due to the heat, and cows produce less milk. NCDEX plans to launch a heat-linked contract one day. Indian companies exposed to weather fluctuations hope that this financial innovation, like the monsoon, will come soon.
For more expert analysis of the biggest stories in economics, finance and markets, sign up for Money Talks, our weekly subscriber-only newsletter.
