Hybrid Weather and Financial Risk in Derivatives

# Basket derivatives on weather AND financial underlying?


# Basket derivatives on weather AND financial underlying?












Is somebody aware whether there exist basket derivatives whose underlyings are either related to weather (e.g. temperature) or financial indices (e.g. S&P500)? It is essential that the payoff depends at least on one financial product AND one weather quantity. I'm thinking about something like a rainbow option with payoff: $$max\{a_1(R_T-K_1), a_2(S_T-K_2),0\}$$ where $R_t$ is a temperature, $S_t$ is the S&P500 and $a_1$ and $a_2$ are constants.

NB: I'm not particularly interested in temperature, but it could be anything related to weather (e.g. snow, rain etc...). Nor I'm particular interested in specific payoff functions.

Thanks

## Answer by Mathias Körner (score 3, accepted)

https://quant.stackexchange.com/a/27565

If you are looking for derivatives on weather (temperature, heating degree days, cooling degree days) and a financial "index", I think your best bet would be to look for hybrid weather/commodity derivatives.

## Answer by M. Jeunesse (score 2)

https://quant.stackexchange.com/a/27582

Please note that this is subjective, but I hope it can help.

I was told that Frozen Concentrated Orange Juice forward contracts (FCOJ) are used to have a proxy for weather risk. https://www.theice.com/products/30/FCOJ-A-Futures you can imagine have a look at other agricultural forwards, since for these kind of market, demand is linked to economy level (=your financial index) and offer is driven by weather conditions(=your $R$).

It exists also a very limited market for Cat Bonds. https://en.wikipedia.org/wiki/Catastrophe_bond

And last, it exists weather derivatives, I know that some big power companies tried to push them in the past, but I worked recently for a big power company, and they stopped to use it as too risky for the seller and too expansive for the buyer. https://en.wikipedia.org/wiki/Weather_derivative

## Answer by Xozorion (score 1)

https://quant.stackexchange.com/a/27557

This is not a direct answer to your question as I am not sure whether the instrument you described exists, but OP would probably find the mathematics behind transmission congestion contracts very interesting.

Transmission congestion contracts enable the hedging of fluctuations in electricity prices across the power grid, and are auctioned off by regional utilities operators. When demand for electricity in a certain area outstrips the immediate supply, electricity prices and operator expenses increase as the grid transmits power from more distant locations. These contracts derive their value from the demand for power at any one of thousands of transmission points (power stations).

They are not basket derivatives and there is no direct relation to weather in the pricing formulae, but as you could probably guess there is a strong correlation with weather in the value of these contracts.

General pricing inefficiencies, heat waves, blizzards, outages etc. can all make for highly profitable arbitrage opportunities. Trading firms large and small have successfully entered these markets in the past 10 years, arguably to the detriment of the power operators these contracts were designed to benefit.

http://www.nytimes.com/2014/08/15/business/energy-environment/traders-profit-as-power-grid-is-overworked.html?_r=0

https://www.computer.org/csdl/proceedings/hicss/2005/2268/02/22680059a.pdf