On
August 25, 2006, the National Oceanic &
Atmospheric Administration upgraded Tropical Depression Number 5, which had
formed the day before, to tropical storm status and gave it the name "Ernesto."
Two days later, the storm officially became a hurricane, the first of the 2006
Atlantic season. Simultaneously, HedgeStreet, an online futures exchange based
in San Mateo, Calif., listed Hurricane Ernesto contracts, and on August 28,
trading began.
 A new market in hurricane risk actually enables investors to
bet on the amount of damage that a particular storm or storm season will have.
As perverse as it may sound, it is now possible to make a profit when a
particular storm turns out to be more severe than expected, or if the hurricane
season turns out to be worse than predicted.
The emergence of a market in storm risk mirrors developments in
the financial markets in general, where new instruments, namely weather
derivatives and catastrophe bonds, let investors buy and sell risk on extreme
events.
These hurricane contracts allow investors to hedge or speculate
on the economic impact of damage caused by hurricanes or tropical storms. During
the 2006 hurricane season, HedgeStreet launched contracts only on those specific
storms that were expected to wreak more than $25 million in insured damages.
"Once a storm becomes named, then we list a contract on it and investors begin
trading it," explains Russell Andersson, cofounder of the company.
As perverse as it may sound, it is now possible to make a profit when a particular storm turns out to be more severe than expected. |
The contracts effectively allow investors to bet on the amount
the insurance industry will need to disburse following a particular storm.
HedgeStreet also lists seasonal contracts that let investors speculate on how
much insurers will have to cough up as total compensation at the completion of
the storm season, which officially ends November 30.
So how exactly do individuals bet on hurricanes, and how are
their returns calculated? HedgeStreet refers to its contracts as "binaries"
because they provide a simple all-or-nothing payoff. Each contract is valued at
$100; investors can bet on damage levels of $25 million, $100 million, $1
billion, $10 billion and $25 billion. For example, a buyer of a seasonal
contract referencing $10 billion would receive $100 for every contract entered
into if the damage for the season is at least $10 billion. A seller would
receive $100 if the total destruction caused by hurricanes and storms is
officially put at less than $10 billion.
As a hypothetical example, toward the beginning of a storm
season, a contract referencing $25 billion in damages might cost $30. If at the
end of the season official figures state that damages total more than $25
billion, then the buyer of that contract gets a $100 return—a profit of $70 per
contract entered. If damage is put at less than $25 billion, then the buyer gets
nothing—a loss of $30 per contract. The box (opposite) gives an example of a
HedgeStreet contract on a particular storm in 2006, showing when it was listed
and how bets could be taken.
Along with HedgeStreet, some of the large exchanges are getting
in on hurricane action. The Chicago Mercantile Exchange (CME) launched hurricane
futures and options in March covering storm damage in five distinct geographical
areas—the Gulf Coast, Florida, the Southern Atlantic Coast, the Northern
Atlantic Coast and the Eastern United States. CME also offers a number of other
weather-related derivatives. Meanwhile, the New York Mercantile Exchange
announced last December that it also intends to list hurricane derivatives. "We
can expect to see more and more of these from the exchanges," Andersson
says.
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