World Bank tests water with Malawi drought risk trade

The World Bank will close a weather derivatives trade by October 1, a move intended to hedge the Malawian government against the financial risk of severe or catastrophic drought.

The pilot trade, approximately $3 million in notional size, is expected to be the first in a series intermediated by the institution aimed at enabling developing countries to hedge against weather risk. Indicative prices for the transaction are being gathered from market participants, and the World Bank intends to finalise terms by the end of the month.

The deal will be part-financed by the UK Department for International Development.

“We’ve been working for about a year and a half on the product development for this transaction, which will essentially hedge the government of Malawi against severe and catastrophic drought,” said Julie Dana, Washington-based technical specialist in the World Bank’s agriculture and rural development commodity risk management group.

The trade will be linked to an index based on the average daily rainfall between October and April across 23 individual weather stations in Malawi. The so-called water requirement satisfaction index will be weighted with a bias towards regions that are more important for producing maize, which is the country’s staple crop. Washington-based remote sensing company MDA Federal will act as an independent monitor.

“The government has been using this model since 1992 to do predictions on maize production, so we’ve adapted it slightly and used it as the basis for an index-based derivatives product,” explained Dana.

Malawi’s rainy season is typically between October and April, and its harvest season follows until around the following July. This means that, when drought hits Malawi, the lean period between October and January becomes particularly fraught, Dana said. In such circumstances, this is usually the time when humanitarian help is called for – well after the prices of food imports have already risen.

In contrast, the payout from the weather derivatives trade would come by April or May. “The payout from this instrument provides contingency financing to the government in a new way, because it’s going to be a very timely and predictable payout that would come much earlier in the process,” Dana explained.

The World Bank is now investigating using any payout from the weather derivatives contract to purchase a call option on maize to lock in future prices.

While a premium of around $3 million is unlikely to go far in meeting food shortages caused by drought, Dana said the pilot transaction was partly aimed at exciting interest among counterparties for taking emerging market weather risk.

Malawi last suffered from drought in 2005, a year that brought widespread hunger to many countries in southern Africa.

While the drought risk transaction is a first for the World Bank, it is one in a series of recent deals that have used weather derivatives technology for humanitarian purposes.

See also: Eyes on the storm
Weather derivatives help fulfil Millennium Promise
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