Terminology
The glossary contains descriptions of weather derivatives terminology. Click on a letter to jump to the appropriate section.
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A
F K P U |
B
G L Q V |
C
H M R W |
D
I N S X |
E
J O T Y/Z |
A
Arbitrage
A transaction which generates a risk-free profit.
At the money
A condition where the value of an option's underlier matches the option's strike price.
See also: In the money, Out of the money
Average daily temperature
The average of the actual daily high temperature and the actual daily low temperature (Tmax + Tmin / 2).
B
Basis risk
Risk from changes in spreads.
Basket
Two or more Reference Stations that are used in determining the specifics of a transaction. The Reference Stations in a Basket can be either aggregated or average weighted.
Benchmark
The standard unit used in determining the Strike. In the case of Degree Days, the Benchmark would be 65 degrees F. (ex. In a TMAX transaction, the Benchmark may be 100 degrees F in Des Moines, Iowa).
Beta
A measure of systematic risk.
Binary option (also known as digital option)
A type of option which features a discontinuous pay-off.
C
Calculation period
The period from and including the Effective Date to and including the Termination Date of a transaction.
Call option (weather cap)
A contract where the buyer pays a Premium to a seller for the potential to receive a Payout if the actual index amount exceeds a predetermined Strike when the contract settles. A Weather Cap is purchased with the expectation of extreme temperature or precipitation.
Call Spread
See Cap
Cap (also known as Call spread)
The maximum payout of a call option. A cap refers to the level below which revenues due to weather conditions will not fall as a result of an option payout.
Capital Asset Pricing Model (CAPM)
A model for valuing financial assets based upon their systematic risk.
City spread
The sale of a contract struck on one city against the purchase of another contract struck on another.
Collar
A contract where the buyer purchases an out-of-the-money Call Option and sells an out-of-the money Put Option, typically, little or no premium is exchanged. This provides protection against reduction in revenue in return for foregoing a proportion of profit.
Compound option
An Option on an Option, where the buyer pays an up-front Premium. If the buyer exercises the Option, the buyer must pay an additional Premium (the Exercise Premium) by a certain date (the Exercise Date).
Contract (tick) size
The HDD/CDD futures have a notional value of $100 times the CME HDD or CDD Index and the contracts are quoted in HDD/CDD Index points.
For example, an HDD Index of 750 would mean the futures contract had a notional value of $75,000 (750 HDD x $100). The minimum tick size would be 1.00 HDD or CDD Index points with each having a value of $100 dollars. Suppose a trader were to go short, or sell, the November 1999 HDD futures on the city of Chicago at a price of 750 on September 10, 1999. If, on October 11, 1999, the trader bought the futures contract back at a price of 625, closing out the position, that would mean the trader would show a gain of $12,500 ($100 times 125 HDD Index points) on the position she took in September.
Confirmation
A written notice confirming the details of a transaction.
Cooling degree day (CDD)
Term created by the energy utility sector to better forecast demand. Difference between the actual temperature, as determined by the average of the high and low daily temperatures, and 65 degrees F (outside temperature above which consumers tend to turn on air conditioning units).
For example, if the daily high temperature is 72 degrees and the daily low is 66 degrees, the actual temperature for that day would be 69 degrees. The CDD's for that day would be 4 (69-65). If the average temperature is less than or equal to 65 degrees, the CDD's for the day would be zero. CDDs are typically used for the summer season. CDDs cannot be negative.
Correlation
A notion from probability.
Counterparty
A party with whom one transacts business.
Credit risk
The risk that a counterparty may fail to perform on its obligations.
Critical Day Options
Options where the payoff is a function of a critical day. A day is termed critical if certain conditions are met.
For example, on each day during the option's lifetime if temperature touches 25 Celsius (77F) then this day is termed critical. The option's payoff now becomes a result of the number of critical days rather than a cumulative degree day or temperature total.
Cumulative degree days
The sum of the daily Heating Degree Days or the sum of the daily Cooling Degree Days over a specified period.
D
Degree day
The deviation of a one day average temperature from a benchmark equal to 65°F. Degree days can be 'heating' or cooling'.
See also Heating degree days, Cooling degree days.
Delta
A measure of exposure to an underlier.
Derivative instrument
A financial instrument who's price or value is derived from the performance of an underlying instrument or index.
Digital option (also known as binary option)
See binary option.
E
Earth Satellite Corporation (EarthSat)
The independent service firm designated by the Chicago Mercantile Exchange to define the degree days indexes to which the weather futures and options contracts are tied.
El Nino
El Nino is a periodic warming of the tropical Pacific ocean which affects weather around the world and occurs roughly every 3 - 5 years. Typical consequences of El Nino include increased rainfall in the Southern US and drought in the western Pacific. Winter temperatures in the north-central states of the US are typically warmer than normal in El Nino years and cooler than normal in the south-east and south-west of the country.
Enterprise risk management
The process whereby an organisation optimises the manner in which it takes risks.
European
European Options can be exercised only on the expiration date. Most weather options trade as Europeans.
Exchange traded
Traded on an exchange, as opposed to being traded over the counter.
Exotic Option
An option whose payoff at maturity depends on the values taken by the underlying asset over the whole lifetime of the option rather than the single value at maturity.
Expected value
The mean or average of a random variable.
Exposure
Sensitivity to a source of risk.
F
Fair Value
The expected value of the option payoff under the appropriate distribution. In general, this will be less than the premium.
Final settlement
The final settlement price for each monthly contract is based upon the HDD or CDD Indices calculated by Earth Satellite Corporation.
Financial engineering
The design of financial portfolios to achieve specified goals.
Financial risk
Financial exposure to uncertainty.
Financial risk management
The process whereby an organisation optimises the manner in which it takes risks.
Floor (also known as put spread)
The maximum payout of a put option. The level below which revenues due to weather conditions will not fall as a result of an option payout.
Forward
An agreement to execute a transaction at some time in the future.
Future
An agreement to execute a transaction at some time in the future.
G
Gamma
A measure of second-order exposure to an underlier.
Good till cancelled (GTC)
An order that remains open until cancelled and can be filled at an undesirable time if forgotten.
Greeks
A set of factor sensitivities frequently used for measuring the exposures of derivative portfolios.
Growing degree days
Base 50. Most common, used for corn. Growing Degree Units are calculated by subtracting a base temperature of 50 °F from an average of the maximum and minimum daily air temperatures for your area. Daily maximum temperatures above 86 °F are counted as 86 °F, and temperatures below 50°F are counted as 50 °F because temperatures exceeding these base temperatures do not contribute more or less, respectively, to growth. So areas with cooler average daily temperatures will take longer to reach a GDU target.
GDU= [(Daily Max Temp + Daily Min Temp)?2] - 50
H
Heating degree day (HDD)
Term created by the energy utility sector to better forecast demand.
Difference between the actual temperature, as determined by the average of the high and low daily temperatures, and 65 degrees F (outside temperature below which consumers tend to turn on heat).
For example, if the daily high temperature is 55 degrees and the daily low
is 35 degrees, the actual temperature for that day would be 45 degrees. The
HDD's for that day would be 20 (65-45). If the average temperature is
greater than or equal to 65 degrees, the HDD's for the day would be zero.
HDDs are typically used for the winter season. HDDs are typically used for the winter season.
Hedging
The act of reducing risk, often through use of financial derivative instruments.
Heteroscedasticity
Non-constant volatility.
High-yield bond
A bond which pays a high yield due to significant risk, for example CAT bonds (MXAgri) and junk bonds (credit risk).
Historical value at risk
A method for estimating value at risk using historical data.
Hybrid deals
Deals structured so payouts depend on a combination of two or more underlyings, such as HDDs and precipitation.
I
Implied volatility
An estimate of volatility based upon market prices of relevant options.
Index
The index is the cumulative number of degree days (or another type of weather condition) over a period for a particular location as measured by the Met Office.
In the money
A condition where an option has a positive intrinsic value.
See also Out of the money and At the money
L
Legal risk
Risk relating to legal uncertainties.
Liquidity
A measure of an asset's ease of trading.
Liquidity risk
Risk from a lack of liquidity.
Lognormal distribution
A type of probability distribution.
Long position
A position which entails ownership or effective ownership of an asset.
M
Market value
The value at which an asset trades, or would trade in the market.
Mark-to-market
Risk exposure based upon the current market values of a counterpary's obligations.
Maximum exposure
The largest potential loss arising from a particular risk.
Maximum payout (Cap)
The maximum amount that the seller of an Option / Strangle or a Swap / Collar participant may be obligated to pay. The Maximum Payout (Cap) is equal to the Per Unit Value multiplied by the Spread.
MCE
Maximum Credit Exposure.
Mean
The average or expected value of a random variable.
Mean reversion
A tendency for a stochastic variable to drift toward a long-term mean level.
Meteo France
The national meteorological office of the UK.
Meteorological Office (MetOffice)
The national meteorological office of the UK.
MM
Short-hand notation for 'millions'.
Model risk
Risk from the misuse of financial models.
Modern portfolio theory
A body of theory relating to how investors optimize portfolio selections.
Monte Carlo simulation
A technique of simulation which uses many randomly or 'pseudo randomly' generated scenarios.
Monte Carlo value at risk
A technique for estimating value at risk.
N
National Climatic Data Center (NCDC)
The government agency responsible for the collection and dissemination of climatic data. It is the independent source from which most US weather transactions are based upon.
National Weather Service (NWS)
The division of the National Oceanic and Atmospheric Administration responsible for providing weather and flood warnings, public forecasts, and advisories for all of the United States, its territories, adjacent waters and ocean areas, or its successor organisation.
Normal distribution
A type of probability distribution often assumed in financial modelling but with only limited applicability to the weather market.
Notional amount
The quantity of an underlier to which a derivative contract applies.
O
Option
A contract that gives the owner the right, but not the obligation, to exercise the terms of the contract. The buyer pays a premium to the seller for the right to a Payout if the underlying Index reaches a predetermined Strike. Weather options include a premium, a period, a location and a Payout. The Maximum Payout is the maximum upside for the buyer of an Options contract. The Premium is the maximum upside for the seller (or "writer") of an Options contract.
If at the end, or expiry, of the contract there is no value in the deal then the option will not be executed.
Option Expiry
The end of the option. This is the date when the holder has the right but not the obligation to exercise the contract.
Option Payout
The amount that the option will pay the holder at the end or expiry of the contract.
Option Writer (also known as the principal)
The seller of the option.
Out of the money
A condition where an option has no intrinsic value.
See also In the money and At the money
Over the counter (OTC)
Not traded on an exchange.
P
Payout
The dollar amount an Option / Strangle buyer or Swap / Collar participant receives at settlement of the contract.
Premium
The price paid to purchase an Option or other financial instrument.
Principal (also known as option writer)
A company that guarantees the option payout in return for a premium.
Probability distribution
A notion from probability.
Purchased put / purchased call
A purchased call is similar to a long position in the underlying security,
except that it has the advantage of insurance against downside movements in
the price of the underlying security. The downside is limited to the option
premium. Similarly, a purchased put is like a short position in the
underlying security, except that it has the advantage of insurance against
upside movements in the price of the underlying security. Again the loss is
limited to the option premium paid. The options market is a zero-sum game,
whatever the option buyer profits, the option writer loses, and vice versa.
Put
A type of option which gives the holder the right to sell the Degree Day index (or another type of weather index) at a predetermined level.
Put-call parity
A formula that relates the price of a put to the price of a corresponding call.
Put option (weather floor)
A contract where the buyer pays a Premium to a seller for the potential to receive a Payout if the actual index amount is less than a predetermined Strike when the contract settles. A Weather Floor is purchased with the expectation of mild temperature or precipitation.
See also Floor
R
Reference station
Specific location at which weather variable is measured under the terms of the trade. This location is identified by several cross referenced identifiers, including WBAN, WMO, and latitude, longitude and elevation coordinates. (ex. Boston Logan International Airport, WBAN #14739, WMO# 72509, 42° 22'N latitude, 71° 01'W longitude, 6.1m elevation)
Reference temperature
The temperature against which Heating and Cooling Degree Days are measured. This temperature is arbitrary but at present users of weather derivatives are typically using 18C or 65F.
Risk
Exposure to uncertainty.
Risk-free rate
A theoretical interest rate at which an investment may earn interest without incurring any risk.
Risk limit
A procedural tool for managing risk.
S
Scenario
A possible set of future events.
Securitization
The creation of security interests in an asset.
Sensitivity
Exposure to a risk factor.
Simulation
Analysis based on determining the consequences of possible scenarios.
Skewness
A notion from statistics.
Specific risk
Risk which is unique to a particular asset or liability.
Speculator
A business, a company or an individual who wishes to take a position in the market - they want to accept risk onto their books, either betting that the underlying will go up or that the underlying will go down.
In the weather derivative market a company can speculate by taking a long or short position in the swap market. For extra leverage they can use options.
Spot
For immediate delivery.
Standard deviation
A notion from probability.
Statistical risk measure
A risk measure which is based upon a probability distribution relating to a risk.
Stochastic process
A random process which evolves over time.
Stop-loss limit
A market risk limit which curtails losses as they occur.
Straddle
A type of derivatives position.
Strangle
A contract where the buyer purchases an out-of-the-money Call Option and an out-of-the-money Put Option.
Stress test
A type of single-scenario risk measure.
Strike (also strike price)
A predetermined level where an option payout occurs.
Swap
A contract where the buyer purchases an at-the-money Call Option and sells an at-the money Put Option, typically, no premium is exchanged. Both transactions have the same Strike. A Swap has the same profit and loss profile as a traditional futures contract.
Swaption
An option on a swap.
T
Theta
A measure of how a portfolio's value changes as a consequence of the passage of time.
Tick Size
See Contract size
U
Uncorrelated exposure
Exposure to a risk factor, assuming that all other risk factors will remain constant.
Underlier
A primary instrument or variable upon which the value of a derivative instrument depends.
Underlying
The security, commodity or other instrument or contract (swap, forward, futures contract) to which the option (or another derivative contract) is tied.
V
Value at risk (VAR) model
Proecedure for estimating the probability of portfilio losses exceeding some specified proportion.
Vega
A measure of exposure to changes in volatility.
Volatility
The variability of a random quantity.
Volumetric risk
The effect of demand for a product or service on revenue.
W
WBAN
A numeric code defining a specific geographic weather station (Weather Beacon Army Navy meteorological station as maintained by designated agencies of the United States Department of Commerce, its successors, assigns or appointees. (ex. John F. Kennedy International Airport, WBAN# 94789)
Weather derivative
A weather derivative is a financial instrument that has a payoff derived
from one or more independently measurable weather factor(s) such as
temperature, rainfall, wind speed, snow depth or sunshine hours as recorded
at one or more specified reference locations. The majority of weather
deals at present are swaps or options based on underlying temperature
indices at single locations.
Weather exposure
A quantifiable risk born by an individual or an organization due to climatic volatility.
Weather hedge
A product that enables an organisation to either partially or fully offset the financial risk due to climatic volatility.
WMO
A numeric code defining a specific geographic weather station (World Meteorological Organization). (ex. Las Vegas Mccarran International Airport, WMO# 72386)