OTC weather trades fall; exchange trades rise

The weather derivatives market is shifting from an over-the-counter market to an exchange-traded one, according to results from a 2004 Weather Risk Management Association (WRMA) survey.

The international trade body for the weather risk industry will today announce at its annual meeting in New York that the notional value of weather risk management contracts transacted from April 2003 through March 2004 increased by nearly $400 million compared with the previous 12 months.

With a total notional value of $4.6 billion, this marks an increase of 10% over the previous year. But the size of the global OTC market has contracted. Last year the OTC market was worth around $3.5 billion. But for the period between April 2003 and March 2004 OTC notionals fell to $2.8 billion - marking a 20% decrease. At its height, in the 2001/2002 survey, the OTC market was worth $4.3 billion.

The number of OTC trades fell from 4,517 last year to 3,162 this year. The 10% rise in overall notional values was due to the success of the exchange-traded weather contracts at the Chicago Mercantile Exchange (CME). This year, the CME reported 21,335 trades compared with 7,239 for last year.

Notional volumes for CME trades were worth around $1.8 billion this year, compared with approximately $750 million for last year. The distribution of weather contracts remained fairly stable by region - although Europe experienced a slight fall in trades and the Asia-Pacific region noted a small increase.

The CME is set to launch Japanese weather futures by the end of the second quarter, said Felix Carabello, CME's associate director for industrial commodities. The CME-cleared contracts have proven particularly successful in the past year due to the influx of hedge funds that trade speculatively and increasing worries about OTC counterparty credit risk between energy companies.

Energy companies are the largest users of weather derivatives, and pioneered the market's development until many US firms such as Aquila and Dynegy exited the market due to credit issues.

Exchange-based weather futures have often failed to make an impact, however. Hex, The Helsinki securities and derivatives exchange, which launched weather futures in August 2002, has moth-balled its contracts following its failure to attract any interest in the offering. And the London International Financial Futures and Options Exchange (Liffe) has terminated its European weather contracts following lacklustre demand.

"The tremendous growth in the number of trades executed on the CME signals a positive shift within the weather risk management industry," said Brian O'Hearne, WRMA vice-president and chief executive of Kansas-based GuaranteedWeather. "The CME helps provide the industry with a heightened level of transparency and liquidity."