Academic rains on weather/return correlation parade
May 29th, 2008 | Filed under: CAIA Alternative Viewpoints Columns, CAPM / Alpha Theory, Guest PostsIn our monthly column featuring the thoughts of a member of the Chartered Alternative Investment Analyst (CAIA) Association, we feature an active publisher in highly rated journals who has recently written an article on weather variables and their impact on financial markets. Wessel Marquering, Ph.D., CAIA, is quantitative researcher at the Talergroup. Marquering and fellow researcher Ben Jacobson wrote an interesting paper on weather and financial markets for the Journal of Banking & Finance. What follows are Marquering’s thoughts on the promise and peril of trying to extract alpha from the weather.
Alpha in the Weather: Alternative Viewpoints, powered by CAIA
Special to AllAboutAlpha.com by: Dr. Wessel Marquering, CAIA, Talergroup
As readers of this website are no doubt aware, weather derivatives trading is taking off - with trading volumes going through the roof and more hedge funds venturing into this space. Basically, a weather derivative is a financial product in which two parties agree to exchange cash flows determined by reference to a weather index. The reference indices include temperature, rainfall, wind speed, humidity, snowfall, to name a few, but the most heavily traded contracts are based on temperature indices.
On the one hand, weather derivatives can be used to manage risk, by insuring for example farmers against a bad crop, as an insurance against bad weather on holidays, by decreasing the exposure to temperature-related risk factors, etc. On the other hand, they have become a relatively new way to generate alpha.
These alpha opportunities arise because weather derivatives are difficult to price. And since weather patterns are not random, the Black-Scholes option model is not entirely appropriate. Some hedge funds actually hire meteorologists and run highly quantitative models to forecast the weather in an attempt to identify bargain contracts. Since the weather is uncorrelated to, for example, sub-prime, Iraq war, etc., they are a great addition to investors’ portfolios.
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