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Marketing the Weather

An image showing plants growing in dry ground

When bad weather threatens to slash profits, firms turn to the national weather market to hedge their losses. Expecting a warm winter in Chicago? An oil company can buy weather futures that would compensate the firm for lost profits if the mercury rises too high. Afraid drought will ravage wheat crops near Kansas City? Farmers can buy futures to cover their losses, too.

It’s an unusual market, but it turns out to be an efficient one. According to Assistant Professor of Economics Ludwig Chincarini, who has been studying weather trading with the help of students, the market price has consistently predicted weather patterns better than even the most complex meteorological forecasts.

“Markets do not overreact, and they do not underreact to unexpected weather patterns,” Chincarini says. “It’s an indication of what people think weather will be.” Weather trading has been around since 1999 and is primarily centered in the Chicago Mercantile Exchange (CME). Weather shares currently can be purchased for 46 cities in the U.S., Australia, Canada and Europe. In 2005, the market was worth more than $22 billion with 630,000 contracts traded over the course of the year.

Chincarini, who has worked as a hedge fund manager and has an extensive knowledge of derivative markets, was fascinated by the efficiency of the small, quirky market—and what lessons could be taken from it and applied to similar markets. “I was talking to students about trading weather, and I thought it was so weird,” he says. “None of the standard derivative models could be used to price weather. So I thought, ‘how do you do it?’” The weather market is comprised of futures contracts that pay off in the event of atypical temperature patterns. Differences between the normal tempera- ture and aberrant temperatures that go too high above or too far below the his- torical norm are summed up at the end of each month. If that sum total exceeds an agreed upon number set down in the contract, then companies receive a pay- out. If not, then the firms get no returns.

Unlike stock market speculators, most participants in the weather market are not looking to turn a profit. Weather traders instead use the market as an insurance policy to smooth out profit over the course of the year. If the weath- er was as bad for business as expected, the contract payouts can help them recoup those losses. Even if a firm does not receive a payoff from their contract because weather turned out to be more normal than expected, the weather should have helped them drum up enough business to cover the contract costs. “As a business, you want to take away from surprises,” Chincarini says.

Although they haven’t yet been able to predict the weather, firms that enter into the market have almost always been successful at removing weather-related risk. Despite being quite small and having very low liquidity, the weather market has been much better than most larger markets at ensuring that the price of futures does not stray from fair market value. Market convention says that the more liquid a market is—that is, the easier it is for investors to buy and sell shares—the more efficient it will be. In his study, however, Chincarini found the opposite was true for the low-liquidity weather market.

So why is the weather market so efficient? Chincarini suggests the impossibility of having and using insider information plays a part. When someone is trading shares of a company, they can cheat the system by gaining insider information on the company’s future earnings. In addition, non-insiders may look at movements in prices as an indication that other traders have inside information and trade accordingly. Getting privileged information on next month’s average temperature in New York, however, is a bit trickier. “Maybe it’s not liquidity that matters so much as the potential for insider information,” the professor says. --Travis Kaya ’10

This article originally appeared in the Spring/Summer 2010 issue of Pomona College Magazine.

Research at Pomona