💸 〽️ 👩🏽‍🚒 Snowmobiles, beer and weather derivatives 👨🏽 ☢️ 🕵🏻

_{Hendrick Averkamp. Scene on the ice . OK. 1615–1630 Taylor Museum, Haarlem.}

The Canadian company Bombardier, known to us for its aircraft, also produces snowmobiles, among other things. Actually, everything started with snowmobiles when Joseph-Arman Bombardier developed the first production models in the 30s of the last century.

In the late 1990s, snowmobile sales in North America stalled and stubbornly refused to grow. Marketers have found an obvious, in principle, thing. Potential customers refused to buy because they feared a warm winter without snow. Few people will like to pay a tidy sum for a toy that will then stand in the garage for the first season at the mercy of Mother Nature.

It would seem that nothing can be done. Weather is a completely unpredictable thing, which can not be influenced either by Bombardier itself, or even less so by retail customers. All that remains is to read the frightening news about global warming and prepare for what will only get worse. Financial innovation came to the rescue, the latest fashion is derivatives for the weather, that is, contracts for which payments depend on weather conditions.

Derivatives on snowfall

Bombardier offered customers insurance. If in the year the snowmobile is purchased, the winter will turn out to be light snowy (less than half the average for the last three years in the given area), then in the spring a discouraged buyer will automatically receive a check for $ 1,000 from the company so that the money brightens up the expectation of next winter. The amount is quite substantial, given that the top model of the snowmobile cost about $ 10,000, while the budget ones sold for $ 3,000. It was a bomb: in the first year, sales grew by 38%!

Of course, no one, including Bombardier, can predict the weather for months to come. It would be too reckless to sit back and wonder if buyers would have to pay compensation.

Bombardier made a deal with energy company Enron, one of the pioneers of the weather derivatives market. For each snowmobile sold, Bombardier paid Enron between $ 40 and $ 450, depending on the city in which the buyer of the snowmobile lived. In exchange, Enron committed itself to paying the same $ 1,000 to Bombardier if the winter was not snowy [ GS99 ]. Thanks to this deal, Bombardier did not risk unexpectedly going broke due to the warm winter.

The deal between Bombardier and Enron is a classic example of a weather derivative. In general, in order to agree on a weather derivative, two parties to a transaction must choose a base indicator (for example, the amount of snow that has fallen at a particular weather station), an observation period (for example, three winter months) and a formula by which you can calculate the final payment from the base indicator (for example, $ 1,000 if there is less snow than half the average for the last three years, or $ 0 otherwise).

Risk redistribution

At first glance, nothing has changed as a result of the deal, because the uncertainty associated with future weather has not disappeared. As before, none of the mortals knew how much snow would fall in the coming winter. In addition, if you are used to looking at the financial market as a zero-sum game, then you could see familiar features in this situation, because the potential profit of the snowmobile buyer is equal to the loss of Bombardier, and the profit of Bombardier is equal to the loss of Enron.

However, an inconspicuous but important thing happened. Derivatives allowed the redistribution of risk among the participants in the scheme. Whereas previously only an unlucky snowmobile buyer suffered from a snowy winter, now he could count on compensation from Bombardier, which, in turn, shifted the risk to Enron.

The mere redistribution of risk has changed the behavior of people who still decided to fulfill their dreams and buy a snowmobile. Bombardier significantly increased sales, and revenue growth more than recouped the cost of a deal with Enron. Finally, since enough snow fell in the 98/99 winter, Enron did not have to pay compensation, and she was able to make good money. Everyone is happy. Real magic, isn't it?

“Wait! - the reader will exclaim, - and what if the winter were not snowy? After all, Enron would have suffered losses! ” In fact, Enron made money because it sold insurance against an event that never happened. Well, this is the business model of insurance companies since the time of Babylon. Presumably, Enron analysts calculated the likelihood of a little snowy winter and set such a price of insurance so as not to remain at a loss on average.

However, Enron could not leave the risk to itself, but shift it to someone else. To do this, one would have to find someone who has the opposite sensitivity to weather risk - one whose business is better when there is little snow, and worse when there is a lot of snow. Who could it be? A farmer who has a better winter crop in case of a warm winter. A municipality that does not spend money on street cleaning. Residents themselves who do not receive giant heating bills. You can continue the list yourself.

Suppose a farmer bought insurance from frosty (not warm!) Winter from Enron. Then Enron will receive an insurance premium from both Bombardier and the farmer. If the winter turns out to be warm, then the farmer’s money will go to Bombardier, which will transfer it to buyers of snowmobiles. If the winter is cold, Enron will compensate the farmer for the losses received from Bombardier.

Aversion to risk and loss

If you remove the intermediaries Bombardier and Enron from the risk redistribution chain, it turns out that the buyer of the snowmobile insured the farmer from the cold winter, and the farmer in return insured the buyer of the snowmobile from the warm winter. Interestingly, this deal can be beneficial to both! The fact is that people do not like uncertainty and even more do not like losses.

To test how much you don't like uncertainty, do a thought experiment. Imagine that you were locked in the basement and offered to choose from two options. First, you can just pay $ 10 and get out of the basement. Secondly, you can play heads and tails for $ 10,000 with 50/50 chances. Regardless of whether you win or lose, you will also be released after the game.

Purely mathematically, the average gain in the toss is $ 0, and this may seem more profitable than the sure loss of $ 10. However, most likely you will probably prefer to lose $ 10 rather than toss a coin, since the possible joy of winning $ 10,000 does not outweigh the possible longing for losing $ 10,000.

It is possible that you will be guaranteed to lose not even $ 10, but all $ 100 or $ 500, only would not play toss. The exact amount that you will be willing to pay depends on your personal sensitivity to risk and loss. Economists call this effect risk aversion and loss aversion.

If you have already moved away from a cruel thought experiment, then apply the knowledge gained to a hypothetical deal between a snowmobile buyer and a farmer.

The buyer of a snowmobile is not so happy with the snow that falls as he is upset by a snowless winter. The farmer is not so happy with the additional harvest in the warm winter, as he is upset because of the crop failure caused by unexpected frosts. They are both interested in limiting their losses in the event of an unfavorable combination of circumstances, therefore they could well agree to insure each other. This is possible because a bad script for one is simultaneously a good script for another, and vice versa.

Derivatives and insurance policies

The ability to make a deal with someone who has the opposite sensitivity to risk is the main difference between financial derivatives (not only weather) and insurance, although there really is a lot in common between them.

When an insurance company sells you a policy, say, against fire, it is unlikely that after that it expects to sell someone a policy against the absence of a fire. The insurance company remains at risk, and if there are too many fires, then it will go bankrupt. For example, one of the turning points in the plot of The Financier, Theodor Dreiser, is the great fire in Chicago, which led to the bankruptcy of insurance companies and the collapse of the stock market.

Derivatives, at least in part, are free from this defect. If the farmer had to pay insurance to the buyer of the snowmobile, this means that the winter was warm, the farmer gathered a good harvest and most likely does not experience financial problems. Of course, the farmer can go broke for reasons not related to the weather. Therefore, for greater reliability, many derivative transactions take place with the participation of central counterparties (which you can read about in the previous article ) or require a deposit.

However, while there are almost always participants with opposing interests on the currency or oil derivatives market, the weather is not so simple on the derivatives market. Often, the seller of insurance does not have the opportunity to conclude the opposite transaction with someone else, and he can only guess if the weather will present an unpleasant surprise. Enron was lucky with a snowy winter, but history also knows examples of bad luck.

Derivatives for beer lovers

In the early 2000s, the organizers of the Oktoberfest beer festival in Munich rightly reasoned that in rainy weather people are more likely to stay at home, and the attendance of the festival is reduced. The organizers applied for insurance at a major German bank in Frankfurt. We agreed that if it rains for more than four days during the two weeks of the festival, the bank will pay compensation for the fifth and every subsequent rainy day.

The bank had no chance of closing a deal with someone else. Indeed, who in their right mind would insure themselves against dry weather in early autumn? A farmer who suddenly fears a forty-degree drought in October? The organizers of the torrential rain festival? In general, the bank had to act as an insurance company and retain the risk.

A team of analysts got the weather report of Munich for more than a hundred years and calculated the cost of insurance, which would allow the bank not to remain in the red. As you can guess, something went wrong. Abysses opened, and the flood washed away the 2002 Oktoberfest. The number of rainy days exceeded the historical record, and the bank paid beer lovers substantially more than expected [ Rod16 , p. 160].

Conclusion

If there are two entities in the economy with the opposite sensitivity to any risk, whether it is the future exchange rate or the thickness of the snow cover, then they can agree on a derivative, that is, agree to share part of the profit in a good scenario in exchange for compensation for losses in a bad scenario.

Rejection of losses and the desire to avoid risk is deeply embedded in the human psyche, so just redistributing the risk can make the participants in the transaction happier. At a minimum, they will sleep better. As a maximum, a new distribution of risk will change their consumer and investment decisions and will contribute to economic growth. Remember this every time you are convinced that derivatives are just a zero-sum game for speculators.

Unfortunately, you can not do without a fly in the ointment. As you may have heard, in 2001, Enron broke into a crash and simultaneously dragged along the audit firm Arthur Andersen. It turned out that the management of Enron very creatively approached financial accounting, for which he received long prison sentences. Who knows, if the winter of 98/99 was warm, then Enron would hide the losses, and the inspiring story with snowmobiles would be just another episode of a high-profile criminal case.

Denial of responsibility

The opinion of the author of the article may not coincide with the official position of Deutsche Bank AG. An article is not an offer or advertisement of any service. Mention of third parties does not imply approval or disapproval. The author and Deutsche Bank remind you that trading in financial markets is fraught with risk and are not responsible for the possible negative consequences of your personal investment decisions.

Bibliography

[GS99] Mark Golden and Edward Silliere. “Firms Insure Against Lack of Snow By Buying Weather Derivatives . ” In: The Wall Street Journal (Jan. 1999).
[Kan13] Daniel Kahneman. Think slowly ... Decide quickly . AST Publishing House, 2013. ISBN: 9785170800537.
[Rod16] Kevin Rodgers. Why Aren't They Shouting ?: A Banker's Tale of Change, Computers and Perpetual Crisis . Random House, 2016. ISBN: 9781473535633.

Snowmobiles, beer and weather derivatives