118 Valuation and Risk Management of Weather Derivatives: The Application of CME Rainfall Index Binary Contracts 1. Introduction Beginning from the late twentieth century, countries around the world started to recognize the urgency and impact of climate change. Moving into the first half of twentyfirst century, extreme climate change has become the “new normal” of our daily life. The key findings of the New Climate Economy (NCE) 2018 report shows that “disasters triggered by weather-and climate-related hazards were responsible for thousands of deaths and US$320 billion in losses in 2017.” (NCE 2018). António Guterres, United Nations Secretary-General also mentions in the 2017 United Nations Climate Change Annual Report that “climate change is the defining challenge of our time.” (UNFCCC 2018). This challenge gradually becomes the “new normal” in the world. On September 23, 2019, government heads, business leaders, subnational actors, youth, indigenous people, and other civil society stakeholders all attended the 2019 UN Climate Action Summit, where bold announcements and commitments were made to reduce emissions, strengthen climate resilience, and mobilize political will for the Paris Agreement. Besides, many scholars pay attention to the climate finance recently, such as Hong, Karolyi, and Scheinkman (2020), Barnett, Brock, and Hansen (2020), and Choi, Gao, and Jiang (2020). How can investors deal with the extreme climate challenge in finance? Are there any financial instruments to hedge the weather risk? The weather derivatives, which were first developed by energy companies.1 In the financial realm, the market responded to the impact of climate change by developing weather derivatives as early as in 1997, when companies from the old economy started to report loss due to extreme weather conditions. According to Jeucken (2010), and Müller and Grandi (2000), weather derivatives are widely used for hedging purposes by industries whose profits are highly affected by weather conditions, or by hedge funds for speculative purposes. The payoff of a weather derivative depends on the underlying weather indices such as temperature, wind speed, or precipitation (including rainfall and snowfall). Since 1999, the Chicago Mercantile Exchange (CME) has played an important role in the weather derivatives market, which has issued temperature, frost index, and snowfall derivatives. Moreover, the CME also issued rainfall index derivatives to provide an 1 Three over-the-counter (OTC) transactions between Willis Group Holdings, Koch Industries and Enron Corporation in 1997 were generally viewed as the beginning of the weather derivatives market. Among these transactions, two were weather futures traded between Koch and Enron, while the other was traded between Koch and PXRE Reinsurance Company with Willis as the intermediary.
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