Derivatives Against Bad Weather
OPINION |

Derivatives Against Bad Weather

ITALIAN HOTEL OWNERS AND TOURIST OPERATORS THAT HAVE INCURRED HEAVY LOSSES THIS SUMMER SHOULD LOOK AT THEIR US COUNTERPARTS, AND LEARN HOW TO MANAGE WEATHER RISK THROUGH NEW FINANCIAL INSTRUMENTS

by Manuela Geranio, Researcher in the Dept. of Finance
Translated by Alex Foti


The summer of 2014 will be go down in history as one of the most anomalous: heavy rain and lower than average temperatures greatly reduced Italy’s tourist flows, especially in the northern and central parts of the country. As a result, the Italian tourism industry suffered heavy losses.
 
In a grey and damp summer, a colorful event was the lawsuit of hotel operators in the Romagna Riviera aimed at weather forecast websites. These were blamed for announcing bad weather with too much advance. Forecasts often turned out to be wrong, but they had already discouraged tourists from coming to the beach. However, suing weather forecasters is not really the most effective weapon the tourism industry can wield. In fact, for this industry weather risk is by all means an intrinsic risk, which deserves to be adequately acknowledged and managed.
 
From an economic and financial point of view, weather risk can be defined as uncertainty about cash flows and earnings caused by unexpected meteorological variations. Typically, such risk has limited economic repercussions when it occurs on a random daily basis (for instance, a rainy day in August will not affect the turnover of a beach establishment much), but economic damage can become huge if adverse weather conditions continue over time (e.g. a week of steady rain will markedly reduce the flow of beachgoers with strongly negative effects on the establishment’s revenues). It is in the latter case that a weather derivative can save the season.
 
A simple example of climate derivative is a swap on mean temperatures, whereby the tourist firm receives a cash flow for each tenth of degree lower than the agreed temperature level (e.g. 28°C), simultaneously agreeing to pay the bank a sum of money for each degree above the threshold level. This would allow the firm to limit losses in case of prolonged bad weather, by paying for the cost of such protection from the extra revenues accruing from periods of favorable weather.
 
Alternatively, if it wants to know the cost of protection from bad weather in advance, the tourist firm could pay a premium and buy a put option, which gives it the right to receive from the bank a sum of money if temperature values are equal to or lower than the agreed strike level.
 
The US financial market is the world’s most active on weather derivatives. The first contracts were developed for the energy industry, and were later extended to agriculture and tourism. In the tourism industry, buyers of weather derivatives are typically ski resorts (based in the US, Canada and Austria).
 
In Italy, weather derivatives still need to be applied to the tourism industry, due to the lack of knowledge about such financial instruments and the limited supply of them by financial intermediaries. Weather derivates could then represent a useful tool for a more effective management of risk in the tourism industry, as well as an opportunity for expansion for the Italian financial services industry.

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