It Is Necessary to Develop the Weather Derivative Contracts: Research in Vietnam

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GlobalIlluminators FULL PAPER PROCEEDING Multidisciplinary Studies

Full Paper Proceeding ETAR-2014, Vol. 1, 111-117 ISBN: 978-969-9948-23-7

ETAR 2014 It Is Necessary To Develop The Weather Derivative Contracts: Research In Vietnam

Doan Thanh Ha*

Abstract

Climate change is increasing the risk that corresponds more to businesses affected by the chang ing weather. In order to hedge the risks caused by weather, need to have the weather derivative instruments to mitigate the negative impact of weather on the economy. In order to hedge the weather risks, it is necessary to have the weather derivative instruments to mitigate the negative impact of weather on the economy. By the observation and descriptive statistics methods, this article focuses on the introduction of the types of weather derivatives and the necessary applications to Vietnam.

© 2014 The Authors. Published by Global Illuminators. This is an open access article under the CC BY-NC-ND license (http://creativecommons.org/licenses/by-nc-nd/4.0/) Peer-review under responsibility of the Scientific & Review committee of ETAR-2014.

Keywords: Weather Derivative, Weather Derivative Contracts. .

Introduction

Derivative contracts as risk management tools are necessary and useful for investors. The 20th century witnessed the agricultural derivatives contracts and derivative contracts that are the basis of goods in foreign currency, securities, interest rates and stock indexes. Today, derivative contracts were beyond the limits of the original contract farming, it becomes a financial instrument to protect the business activities of the enterprise and the weather derivative contract is born the objective necessity of the development. In fact, no research has discussed this issue in Vietnam, on all aspects. This article focuses argues the need to develop weather derivative contract in Vietnam. To perform this study the authors analyzed

*All correspondence related to this article should be directed to , Doan Thanh Ha, Banking University of Ho Chi Minh city Email: [email protected]

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qualitative methods based on the synthesis of theoretical foundation, and analyze specific situations in Vietnam. The study uses statistical data about temperature change of weather in some provinces representing two climate zones in Vietnam, which shows the changes in the weather affect economic sectors such as agriculture, transport, energy, culture, sports, etc...

Literature Review

Weather derivative contracts first appeared in the US in 1997 to hedge weather risks. Many economic sectors affected by the weather as agriculture, energy, insurance, tourism, retail, etc…Weather derivatives support these industries manage risks caused by weather, the same way that the traditional derivative contracts to hedge interest rate risk, foreign exchange risk, etc.

Weather risk and weather derivative contracts

Weather risk is the uncertainty about cash flows and earnings caused by weather events such as heat, fog, rain, snow, water volume, wind. These weather events do not include natural disasters such as earthquakes, tornadoes, hurricanes, typhoons, etc. Weather risks have a tremendous influence on the business. The revenues of companies in tourism industry are reduced in the rainy season or cold weather. The aquaculture enterprises may be damage caused by rising temperatures. Table 1 illustrates clearly the impacts of types of weather risks on each industry.

Table 1: The relationship between weather and financial risks Industries Weather type Risk Energy Temperature Lower sales during warm winters or cool summers Energy Temperature Higher heating/cooling costs during cold winters/ Consumers hot summers Food product Temperature Lower sales during cool summers Building Temperature/Snowfall Lower sales during severe winters (construction Materials sites shut down) Construction Temperature/Snowfall Delays in meeting schedules during periods of bad weather Ski Resorts Snowfall Lower revenue during winters with below-average snowfall Agriculture Temperature/Snowfall Significant crop losses due to extreme temperatures or rainfall Municipal Snowfall Higher snow removal costs during winters with Governments above-average snowfall Hydroelectric Rainfall Reduce revenues if drought happens power

Source: www.climetrix.com

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The impacts of weather are often measured by the target of the sensitivity revenue (or cost) with weather index (dR/dW). To hedge weather risks, people develop weather derivative contracts, and add some characteristics to these contracts to hedge weather risks more suitable. In general, the weather derivative contracts have the following basic characteristics:

Basis index: Most of the weather derivative contracts trading are based on the basis index is heating degree-days (HDDs) and cooling degree-days (CDDs). Degree days are the difference of the average daily temperature with 650F (1800C) or 750F in high temperature environments. Average daily temperatures are calculated by the arithmetic mean between the highest temperature and the lowest temperature in a day. The value of HDD is lower limiting deviation of average daily temperatures compared to 650F, is the temperature at which people start to get warm; while the CDD is the number of upper limiting deviation of average daily temperatures compared to 650F, is the temperature at which people start to use air conditioner tocool. Daily HDD = Max (0, 650F- Average daily temperatures). Daily CDD = Max (0, Average daily temperatures – 650F). Some other weather derivative contracts are based on rainfall or snowfall is measured during a particular period of time. However, estimated 98% -99% of the weather derivative contracts are based on temperature. HDD and CDD are cumulative over a period and in most cases, this period is a month or a season. This is also the maturities of weather derivative contracts. Maturity: All weather derivative contracts must identify the beginning date and ending date. The most common duration of weather derivatives market is from November 1 st to March 31th for winter contracts and from May 1st to September 30th for summer contracts. April and October are usually considered the mid-month. However, the contracts for several years to a month or a week were included in the transaction in accordance with the development of the weather derivatives market.

Observation location: All weather derivative contracts are based on real observations about the weather at one or more locations are identified. Most contracts based on an observation location, but some contracts are based on the arithmetic mean of weather index of some observation locations. The Chicago Commodity Exchange (CME) has been including future contracts and option contracts based on HDDs and CDDs in few residential areas, the energy centers that suffer many weather risks across the United States and several European cities. The London International Financial Futures and Options Exchange (LIFFE) only trade weather-futures contracts. These contracts are paid in months and the winter index based on the average daily temperature in Europe cities.

The trading market for weather derivative contracts

Most of the weather derivatives have traded on OTC markets including option contracts, put options, swaps contracts. CME and LIFFE have traded the standardized weather derivatives contracts. The trading on the OTC market brings convenience to the parties take part in the contract. Contracts can be flexibly set the conditions for basis index, duration and observation location, etc… consistent with the needs of the parties. However, OTC trading can be vulnerable to

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credit risk for the parties to the contract when they do not perform their obligations. Johnson and R.Slulz, (1987) show evidence that credit risk is more likely to occur in the weather derivatives trading on OTC market and the need to be vigilant. Because of the bankruptcy of Enron (a greatest corporation about derivative contract transactions in the United States), analysts have more cautious when assessing the creditworthiness of the energy trading company. Trading on the Exchange may help the parties avoid credit risk by trading mechanism closely by the Exchange established. However, the parties will bear fundamental risks that the observation locations in the contract is not the location you want. More specifically, Exchanges offer a number of cities as sites for monitoring in weather derivative contracts, while the OTC market includes most of the city. Participants may wish to hedge weather risks at point A, but this point is not found in the list of locations can be set up weather derivative contracts are specified by Exchanges. However, participants can reduce this risk by choosing a city with weather characteristics closely resembles the desired city. According to previous studies, basic risk significantly impact to using of derivative instruments of enterprises to reduce the weather risks (Ederington, L., 1979). Brockett, Wang and Yang (2003a) analyzed the underlying risk and protective effect of weather derivative contracts based on HDD-CDD index for American electricity market. Based on the analysis, they concluded that the small companies (electricity production factory is located in one or several places) should not hedge weather risks by trading on the Exchange as the basic risks are too large.

The development of weather derivatives market

The introduction of weather derivatives market is marked by Koch Industries Company and Enron in 1997-1998, Milwaukee winter based on index HDDs. After, this new market is rapidly expanding worldwide. The weather derivative products are common in markets such as America, England, Australia, France, Germany, Norway, Sweden, Mexico and Japan. The rapid growth of weather derivatives market has changed the thinking of the companies about the dependent of the weather in their business. Nowadays, they can actively prevent this risk, especially for electric industry and gas energy industry that depends very much on the weather. Today, the huge demand on the weather derivative products is not only from the energy sector, but also agriculture, insurance, tourism and retail. On the supply side of the weather derivatives market, there are many components involved in the provision of products to manage the weather risks. The energy-trading companies, the insurance companies and the capital market are the market maker for weather derivatives. Like other derivatives, weather derivatives have great potential to become a new asset for investors to diversify portfolios.

Results And Discussion

Vietnam lies entirely within the tropical belt of Northern Hemisphere, is more inclined to tropic than the equatorial line. That position has given Vietnam a high temperature. Its annual average temperature is from 22 º C to 27 º C. Every year, there are about 100 rainy days with average rainfall from 1,500 to 2,000mm. Air humidity is approximately 80%. The number of sunshine hours is approximately 1500-2000 hours and

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the average annual radiation is 100kcal/cm ². Besides, monsoon also makes the humid tropical climate of Vietnam changed. In general, Vietnam has a hot season with lots of rain and a relatively cold season, less rain. Based on that general temperature, the climate of the Northern provinces (from Hai Van Pass to the north) changes over four seasons: Spring, summer, fall and winter. Depending on the evolution of the northeast and southwest monsoon that climate of Vietnam is unpredictable: there is warm year, there is cold year, winter has come early and opposite, with rainfall years, there is little rainfall years; with rain early years, with rainy years later. Table 2: Yearly average temperatures of Lang Son and Hanoi provinces in cold season Province t0C average The cold year The hot year Fluctuate January Lang Son 13,70C 7,80C 17,90C 4-50C Ha Noi 16,60C 12,30C 200C 40C Source: General Statistics Office of Vietnam (2013) Table 3: Yearly average temperatures of Lang Son and Hanoi in hot season Province t0C average July The hot year The cold year Fluctuate Lang Son 27,10C 28,10C 25,80C 1-20C Ha Noi 28,70C 30,80C 27,90C 1-20C Source: General Statistics Office of Vietnam (2013) Table 4 shows the average temperature and average temperature fluctuations by monthly of some provinces and cities nationwide. Yearly temperature fluctuations of some provinces is quite large, from 0,8 - 5,80 C compared with an average temperature of that province. Table 4: Average air temperature by month in May 2013 in some provinces

Units: 0C Month Standard Province Average 1 2 3 4 5 6 7 8 9 10 11 12 Deviation Lai Chau 15.9 15 20.1 24.8 26.1 27.2 27.4 27.4 27.1 24.9 21.1 18.1 22.9 4.7 Son La 11.7 16.7 16.4 22.1 24.1 25.5 25.5 25.1 24.5 21.7 18.7 14.7 20.6 4.8 Tuyen Quang 12.5 17.6 17 23.4 26.4 29 29.1 28.4 27 23.9 22.2 16.5 22.8 5.6 Ha Noi 12.8 17.7 17.1 23.8 27.2 29.5 29.9 28.9 27.5 24.5 23.9 17.4 23.4 5.7 Bai Chay 12.8 16.4 16.3 22.5 26 28.9 28.9 28.1 27.1 24 23.2 17 22.6 5.6 Nam Dinh 12.5 17.2 16.5 23.1 26.6 29.6 29.6 28.9 27.1 23.9 23.3 17 22.9 5.8 Vinh 14.2 17.7 16.9 23 27.4 30.5 29.7 28.6 27.2 23.9 23.3 17.1 23.3 5.6 Hue 17 19.4 18.9 23.9 27.1 28.7 29 28.4 26.7 24.6 23.6 18.6 23.8 4.4 Da Nang 20 21.5 21.5 24.9 28.1 29.3 29.7 29.2 26.9 25.6 24.6 20.8 25.2 3.6 Qui Nhon 22.8 23.8 23.8 26.3 28.9 30.5 30.4 30.2 29.2 27 26.2 23.6 26.9 2.9 Pleiku 18.5 20.1 21.2 23.1 23.8 22.5 22.3 22.5 21.8 21.8 21.5 19.7 21.6 1.5 Da Lat 15.9 16.5 17.4 18.6 19.9 19.3 18.9 19.1 18.7 18.5 18.2 16.4 18.1 1.3 Nha Trang 24 24.6 25 26.5 28.5 28.8 28.1 28.6 28.7 26.9 26.4 24.4 26.7 1.8 Vung Tau 25.8 26 27.3 27.7 29 28.3 27.8 28.2 27.8 27.8 27.7 26.3 27.5 1.0 Ca Mau 26.3 26.4 27.4 28 28.7 28 27.7 27.9 27.2 28.1 27.5 26.4 27.5 0.8 Source: General Statistics Office of Vietnam (2013)

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Table 5 illustrates the seasonal temperature fluctuations. The data is divided into the hot season (from May to September) and cold season (from November to March). A winter temperature has fluctuated from 0,6-400C, higher than the temperature fluctuations in the hot season (0,3-1,40C). The reason is due to the particular climate of Vietnam: The unity of the prevailing air masses makes temperature fluctuations is not very high in relation to the average temperature.

Table 5: The seasonal temperature fluctuations in several provinces in 2013 Units: 0C 11-3 months 5-9 months Standard Standard Average Deviation Average Deviation Lai Chau 18.0 2.6 27.0 0.5 Son La 15.6 2.6 24.9 0.6 Tuyen Quang 17.2 3.5 28.0 1.2 Ha Noi 17.8 4.0 28.6 1.2 Bai Chay 17.1 3.8 27.8 1.2 Nam Dinh 17.3 3.9 28.4 1.4 Vinh 17.8 3.3 28.7 1.4 Hue 19.5 2.5 28.0 1.0 Da Nang 21.7 1.7 28.6 1.1 Qui Nhon 24.0 1.3 29.8 0.7 Pleiku 20.2 1.2 22.6 0.7 Da Lat 16.9 0.9 19.2 0.5 Nha Trang 24.9 0.9 28.5 0.3 Vung Tau 26.6 0.8 28.2 0.5 Ca Mau 26.8 0.6 27.9 0.5

Source: General Statistics Office of Vietnam (2013)

Vietnam’s economy is now heavily dependent on the agricultural sector and the agricultural service sector that these sectors depend heavily on weather risk.

For agricultural production: rising temperatures, temperature fluctuations along with other weather factors and natural disasters increase the development possibility of pest, disease leading to low productivity and output and increase agriculture risks as well as food security. Temperature changes also affect other areas such as energy, transport, industry, construction, tourism, trade, etc. Rising temperatures also have an impact on the energy sector including rising costs of ventilation, cooling pit mining, decreasing performance and output of the power plant; The domestic consumption of electricity increase and cooling costs of industry, transport, trade sectors and other sectors also increased significantly. Rising temperatures has been accompanied by increased evaporation combined with erratic rainfall regime that lead to water storage change and water flows into hydropower reservoirs. For the transportation sector: rising temperatures increases the energy consumption of the engine, including cooling requirements, ventilation within transport vehicle also contribute to rising costs in this industry.

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For industrial and construction: Temperature changes reduce the life of the material, components, machinery, equipment and buildings requiring the increased cost to fix. For culture, sports, tourism, trade and service sectors: Rising temperatures and the shortening of the winter reduce the attractiveness of tourist resorts, famous resorts in the high mountains while the summer tourist season can be extended.

Conclusion

The process of urbanization and rising greenhouse phenomenon has unpredictable climate changes in the past and this is a big challenge for countries and businesses. Through this study shows the weather in Vietnam affecting many sectors of the economy. Therefore, standing on the micro level of the enterprise, to reduce risks caused by weather necessity of developing weather derivative contracts in Vietnam. However, to develop the weather derivative contracts in Vietnam to need for more detailed research on the organizational structure, technical implementation as well as the governing law for weather derivative contracts in Vietnam.

References

Brockett, P.L., M.Wang and C.Yang, (2003a), Basis Risk and Hedging Effectiveness of Weather Derivatives, Working paper, University of Texas at Austin. Edrington, L., (1979), The Hedging Performance of the New Futures Markets, Journal of Finance, 34: 157-70 Johnson,H., and R.Slulz, (1987), The Pricing of Options with default risk, Journal of Finance, 42: 267-280 General Statistics Office of Vietnam (2013) www.climetrix.com

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