Introduction
A derivative is a financial instrument whose price is determinable by an underlying asset. This instrument requires little initial investment compared to other contracts that serve the same purpose. Its settlement is possible at a future date (BPP, 2010). Derivatives’ designs allow them to hedge against fluctuations of the underlying asset that may include changes in commodity price, interest rate and foreign exchange rate. Additionally, a derivative is useful for speculative reasons. There are four types of derivatives forwards, swaps, futures and options (Chance, 2003).
Weather Derivative
A weather derivative is a type of derivative used to hedge against losses associated with changes in weather. These derivatives trade in a special market of weather derivatives. A weather derivative must have a start and end date, a measurement station, a weather variable that is measured at the weather station, an index that sums up the weather variable and a pay-off function that converts the index into cash flow at the end of the contract period.
A natural gas company that supplies gas in winter to households for heating will be used as an example to illustrate how the weather derivatives work. This natural gas company is listed in the stock market. Due to global warming, the winter season is warmer than expected; this then means that few households turn on the heating system. Consequently, the company makes low sales resulting in low profits. Low profits have the effect of resulting in reduced share prices for the company in the stock market, increased risk of bankruptcy, and the banks will charge a higher interest rate to the company in the event that financing is required. To hedge against this the company can purchase a forward contract in which the company will be paid a certain amount of money based on the pay-off function calculated based on the weather variable index summed up by the measurement station (Stern, 2005).
A forward contract obliges the holder to purchase or sell a definite amount of a specific underlying asset at a specified price at a determined future date (Cooper & Martin, 2005). In this case, the natural gas company can enter into a contract to be paid a certain amount of money for each day the temperature goes above 10 degrees during winter. The company is not compensated for the full amount of profit lost because of changing weather but a difference is expected between the profits lost and the amount compensated (Helyette, 1999). The purpose of the forward then will be to reduce the volatility of profits from period to period for the benefit of ensuring that the share price is stabilized despite fluctuations in sales due to warmer winter, reduced bankruptcy risk and therefore banks will lend money to the natural gas company at a lower interest rate (Brix & Ziehmann, 2005).
Conclusion
Derivatives put the company is in a position to align its finances well without the fear of uncertainties. The amount of monies that these derivatives save for the company is so much when we consider the fact that insurance is not factored in. This means that the company operates in an almost certain environment which is quite healthy for competitiveness.
Reference List
BPP. (2010) Corporate Reporting. London: BPP Learning Media.
Brix, A. & Ziehmann, C. (2005) Weather Derivative Valuation. Chicago: Cambridge University Press.
Chance, D. M. (2003) Analysis of Derivates for the CFA Program. Virginia: CFA.
Cooper, P. & Martin, T. (2005) Hedging Instruments and Risk Management. London: McGraw-Hill.
Helyette, G. (1999) Insurance and Weather Derivatives: From Exotic Options to Exotic Underlyings. London: Risk Books.
Stern, H. (2005) Evaluating The Cost Of Protecting Against Global Climate Change. 16th Conference On Climate Variability And Change. San Diego: Conference on Climate Variability and Change.