2007・3
On Weather Derivatives and Temperature Swapping In Japan
Atsushi Takao

On Weather Derivatives and Temperature Swapping in Japan
Atsushi TAKAO*
Abstract.
Until recently, the meteorological disturbances to the managementof economic entities had to be simply accepted; however, several
financial tools have been developed, with which we can cancel out
the adverse influence of meteorological events. This paper will
intend to examine 2 types of tools, weather derivatives andtemperature swapping, which have been shown to work in Japan.

Key Words: financial engineering, catastrophe risk, HDD(heatingdegree days), CDD(cooling degree days)
１．Introduction
In Japan, we have a saying that nobody can control
the weather; it is an “Act of God”. The weather can
exercise a great influence on the output of industry or
firms, especially in the field of agriculture. Of course,
while such entities can not control the weather, theycan protect themselves from the potential bad
influence of the weather by using any risk
management tools.
Until recently, however, there have been no such
effective tools. As Mizushima (2006) has emphasized,
the insurance system does not work well in
weather-related risky situation because the fluctuationof income due to changes in the weather almost
always falls into the category of “speculative risk,”
which is impossible to insure; and because, in mostcases, changes in the weather are not subject to law oflarge numbers, on which the insurance system isbased.
In recent years, weather derivatives have beendeveloped in order to overcome such a limitation ofinsurance. In their earliest appearance, ENRON andKoch developed “energy derivatives” in August,1997(cf. Hijikata(2000)). In June 1999, the Himalaya
Co. of Japan signed a contract with theMitsui-Sumitomo Marine & Fire Insurance Co. for a* Graduate School of Business Administration, Kobe University“Snow Depth Index Option.” After 3 more years, thescale of this market had expanded to an annual tradeof ￥30 billion, and it continues to expand even more
rapidly today.
There are 2 reasons why we focus on these newfinancial tools. First, on the supply side, financial
engineering has made great advances. Here, financial
engineering is defined as the quantitative method, withwhich investor can make various financial tools (so to
speak “derivatives” such as option, swap, etc.) in orderto hedge his risk and attain more gain with certainty.
Second, on the demand side, not only expected profit
but also its stability are highly valued, related toinvestor relations (IR), which has recently become oneof the most important concepts in the securities market.
In order to set stock value to the high level, any stockcompany must now keep its profit stabilized.
This paper will review two representative types offinancial tools that help offset risks due tometeorological disturbances.
２．Scheme of Weather Derivatives
Generally speaking, if insurance becomesfunctionless against any risks, then ART (alternativerisk transfer) emerges, which is a mode of risk transfer
other than insurance. For example, in Fig.1, thealternatives are substitutes or complements for eachother.

Fig.1. Classification of ART
Source: Swiss Reinsurance Company(2003), fig.4.
Here we follow the definition of weather derivatives
given by the Japan Meteorological Agency(2002):“financial goods that compensate profit shortfalls
because of extreme weather trends.” There are many
types of trends(rain, snow, humidity, wind, etc.), but
most are dominated by temperature (see Table. 1).

daily CDD≡Max(0,daily average temperature－o(2)65 F )
Here, daily average temperature≡(maximal temperature from 0:00 to 24:00+minimal
temperature from 0:00 to 24:00)/2
Equations (1) and (2) mean that we shall choice thelarger variable out of the two in the right bracket. Theotemperature of 65 F (ahrenheit) is equal to 18.33℃(elsius),which is the most comfortable temperature forthe average American and also “the benchmark whichis the fork of hotness and coolness”(Hijikata(2000),p.19).
Equations (1) and (2) are calculated on a daily basis,but very often temperature derivatives are used on acumulative basis. Transferring equations (1) and (2)into cumulative formulas, we obtain:cumulative HDD
o=ΣMax(0, 65 F－daily average temperature )(1)’cumulative CDD
o=ΣMax(0, daily average temperature－65 F )(2)’There are two types of weather derivatives: theoption type and the swapping type. Here, we devote
our attention only to the former; the latter will bereviewed in Section 3 below.

Table.1. Trades by Type of Contract, National
Value of Contracts(Including CME)
Source: Results of the 2005 PwC Survey,
Presentation to Weather Risk Management
Association by John Stell, November 9,2005.p.21(Price Watherhouse Coopers)

Fig. 2.

Thus, we will focus only on weather derivatives that
use temperature as
an index. For ourtemperature-related indexes, heating degree days(HDDs) and cooling degree days (CDDs) are definedas follows:odaily HDD ≡ Max(0,65 F － daily averagetemperature )(1)

In Figure 2, we set the cumulative CDD to thehorizontal axis, just like the market price ofunderlying assets in an option pricing model (OPM;Payoff of weather derivative (temperatureput option) in a hypothetical refreshment
drink company.
Source: Hijikata (2000), Fig.1-1.
Note: a little retouchedBlack and Scholes (1973)). Both variables are“exogenous,” meaning that no one can control themarbitrarily.
Now, let us review the CDD put option scheme byHijikata (2000), which is used to protect theoption-holder against a cool summer. First, we assume
that during a cool summer, a hypothetical refreshment
drink company will earn only half of its expectedsales in July and August. Second, let us set the premise,based on existing records, that the company’s balance
sheet will be in the red of $15,000/CDD only if theoaverage temperature is less than 78.7 F. In this case,the company (option-holder) buys the put option,
which is indemnified such that the option-writer will
pay the holder $15,000/CDD only if the cumulativeoCDD is less than 850 F (=31days x 2 months x (78.7oF -65 oF)) from the beginning of August until the endof September. Here, we assume the upper limit of theoption-writer’s indemnity to be $3 million and theoption premium be $0.5 million.
On the one side, the option-holder obtains thecomposite position, which is produced from a(vertical) summation of the original payoff (a straightoline that passes the cumulative CDD of 850 F with aotangent at 45 ) and the payoff of this put option,owhich is located in the cumulative CDD from 650 Fo-850 F as a fixed cost of $0.5 million in the 4thquadrant. In other words, this company’s gain
becomes stabilized. Here, we must take note of akinking of the payoff line of this put option atocumulative CDD 650 F. There are two reasons for
this: (1) the option-holder can save option premium;(2) based on the past experience, it is rare for aocumulative CDD to be less than 650 F. On the otherside, the favorable composite position, at which theocumulative CDD is over 850 F, takes the form of the45o angle and from the original payoff payment, i.e.,
an option premium equal to $0.5 million down.
３． Temperature Swap Scheme
In Section 2 above, we saw that the option-holder(risk-hedger) must pay a premium as a reward to theoption-writer (risk-taker) in weather derivative trade.
In contrast, no payment is performed ex ante in theswap transaction. Let us consider the interesting
example of a temperature swap contract between theTokyo Electric Power Company (TEP) and the Tokyo
Gas Company, signed in July 2001 in Japan(Mizuho(2003), pp.49-50). The former had faced therisk of an unusually low demand for electric power for
air conditioning because of a cool summer, while thelatter had faced the risk of unusually low demand forgas to heat water because of a hot summer. Therefore,
the two parties have conflicting interests with regard
to summer temperature.
Here, we assume that the two companies reach to abreak-even point in a moderate summer. Given thisbackground, they establish a scheme of swapping therisk of an excessively hot summer with that of anexcessively cool summer. The outline of the scheme isas follows:
1. The companies concerned directly (i.e., not throughan intermediary) swap their own risks, by which
2. One of them shall make up for the other’s deficit ofexcessive temperature by their respective gain.
3. They calculate the equivalent risk and make thetransaction at no cost.
4. Their income and outflow are then theoreticallycancelled out in the long-term contract.
Following this scheme, the TEP has selected theTokyo Gas Co. as its partner. According to the“Response Analysis of Ordinary Profit” of thesecompanies, it was determined that the profit structure
showed a distinct reverse correlation, especially insummer, as shown in Figure 3.

Fig.3.Comparison of the revenues structure of theTokyo Electric Power Co.and the Tokyo Gas
Co.
Source: Mizuho(2003), p.78.

Therefore, these companies agreed upon a contract
for swapping temperature risk, with the following
details:
1. Term of contract: August 1, 2001 to September 30,
2001 (61 days)
2. Index: average temperature per day according to
the Tokyo district meteorological observatory
3. Reference temperature: 26 ℃
4. Payment temperature on the side of the TEP:
reference temperature+0.5 ℃ (=26.5 ℃)
5. Receivable temperature on the side of the TEP:
reference temperature -0.5 ℃ (=25.5 ℃)
6. Maximal exchange amount: approximately ¥ 0.7
billion (reference temperature ±2.0 ℃)
This contract states that if the average temperature
is higher than 26.5 ℃, the TEP must make a payment
to the Tokyo Gas; inversely, if it is lower than 25.5 ℃,
the Tokyo Gas must pay the TEP. The summer hadcool temperature, so at the time when the contract
expired, the Tokyo Gas paid the TEP ¥0.32 billion.

Fig. 4.

Payoff line of temperature swapping of theTokyo Electric Power
Source: Mizuho(2003). p.78.

Thus, as shown in Fig.4, the payoff line of the TEP
with hedging has approached a horizontal line. Thismeans that with the temperature swap contract, thegain of the TEP was stabilized with respect totemperature variance.
４．Conclusion
In the paper, we have reviewed two types ofweather derivatives created in order to raise the valueof an enterprise by stabilizing profit. We can not inthis space estimate the prospects of these derivatives
in the future, but we have had favorable reactions todate, both at home and overseas.
Let us cite here finally the comment of the SwissR e i n s u r a n c e C o mp a n y ( 2 0 0 3 , p . 4 0 ) : “W e a t h e rderivatives were adopted mainly in energy sectors.
These financial tools markets are vastly wide. The
sales in the areas of agriculture, construction,sightseeing, clothing, foods and soft drink depend very
greatly on the weather. According to some estimation,
33% of the U.S. Economy, i.e., $3.3 trillions, isinfluenced by the weather. As the weather derivatives
market is growing up, more industries will become tomake use of those derivatives, in order to hedge their
undesirable outcome, which will be brought bymeteorological variations.”［2007.1.18 794］
References
Black, F. and M. Scholes (1973) “The Pricing ofOptions and Corporate Liabilities”, Journal ofPolitical Economy 31, (July/August), 637-659.
Hijikata, K.(2000) Sohron Tenkou Derivative(GeneralRemarks:WeatherDerivatives)Tokyo:Shigumabeisukyapitaru(in Japanese).
Hijikata, K. (2001)Sokaisetsu Hoken Derivative (TheNew Risk Hedge Solution)Tokyo: Nihonkeizaishinbunsha .(in Japanese)
Japan Meteorological Agency (2002) Kigyo noTenkourisuku
toChuuchouki
KishouYohou no Katuyou ni Kansuru Chousa (A survey ofMeteorological Risk in Enterprise and Middle andLong Term Use of Weather Forecast) Tokyo: Japan
Meteorological Agency.(in Japanese)
Mizuho (1st Financial Technology) (2003) Tenkourisukumanejimento heno Ansanburu Yohou no
Katuyou ni kansuru Chousa (A Research on
Application of Ensemble Forecasting to WeatherRisk Management), Tokyo: Mizuho Bank. (inJapanese)
Mizushima,K.(2006) Gendaihokenkeizai(The ModernInsurance Economy),Tokyo:Chikura.(in Japanese)
Swiss Reinsurance Company(2003) “ActualConditions of Alternative Risk Transfer,” Sigma
No.1, Zürich: Swiss Reinsurance Company.
Takao, A.(1995) Hoken to Opushon: Deribatyibu noIchigenkei ( The Insurance and Option: One Typical
Model of Derivatives), Tokyo: Chikura.(inJapanese)
Takao, A. (2004) Ijousaigai Risuku no Shoukenka－Daitaiteki Risuku Iten(ART) nikansuru
Ichikousatu－ (Securitization of Catastrophe Risk
－A Note on Alternative Risk Transfer－)
Songaihokenkenkyu (Quarterly Journal of
Research on Non-Life Insurance), Tokyo:
Songaihokenjigyou Sougou Kenkyusho( Research Institute of the Non-Life InsuranceBusiness),185-204.(in Japanese)Fig. 1:risk carrier・self insurace/captive・risk retension group・pool

alternative・capital market

solution・finite risk(re-)insurance
・contingent capital
・MMP,MPT
・new asset risk solution
・weather derivatives
・securitization/insurance-linked-security

Table 1.
item that became to object
dateｍarket

share(％)

2003/4

2004/5

HDD

57

56

CDD

1935

Other Temperature

207

Other42Total100

Fig. 2 :＋Original position

Gain

Payoff of option without premium$3x106Composite$2.5x106

8500position$0.5x106

(ºF)

●650

Cumulative CDD
Payoff of option with premuim－LossFig. 3↑revenues
temperature
response oftemperature

Tokyo Electric Power

response ofTokyo Gas

reverse directionof risk
same direction of risk→０monthly average temperatureFig. 4
payoff without
revenues

no payment

income of←hedge→

T.E.P.

payoff with hedgeo

24 cpayment
ofo

25.5 clow←oo26.5 caveragetemperature→

T.E.P.
28 chigh