Weather Risk Management: Considering the Options

Weather derivatives are instruments used to hedge financial risks arising from adverse weather. The existing literature on the topic is dominated by theoretical pricing and use cases, empirical analyses, and several niche studies. This thesis conducts an analysis of the trading patterns and volumes of CME temperature futures and options. It contributes to the literature by complementing the existing empirical work on pricing. There are two strands to this research: examining recent trading patterns and conducting a regression analysis of trading volumes over a longer timeframe.

Recent option trades in the most liquid markets are shown to be balanced between hedging warmer and colder weather, and it is shown that such trades are hedging regularly observed deviations from average temperatures rather than extremes. The latter result is obtained through the introduction of a novel classification scheme. Options volumes are shown to be significantly higher than futures and this may be due to the threshold nature of weather risk.

A regression analysis of monthly trading volumes over the period January 2012 to February 2024 is conducted using dependent variables from three categories: climate indices, financial conditions, and related markets. Futures and options exhibit differing pat- terns of trading volumes, so the regressions are conducted separately for futures volumes, options volumes, and the ratio of options to futures, with each producing differing statistically significant variables.

Key findings are that, for futures and the ratio, both climate indices and financial conditions produced significant variables, while for options it was only financial conditions. This is consistent with, and complements, the existing literature which shows that these two categories impact market prices. Future research could investigate this relationship further by expanding the set of variables in each category and assessing the suitability of options as a preferred hedging tool in the context of this market.