Trust Wall Street to come up with a way to make money off hurricanes.
Weather derivatives have been around for decades, but futures contracts related to hurricanes are fairly new. The Chicago-based CME Group, which manages the world’s largest commodities markets, came up with a hurricane index after the epic hurricane season of 2005 – the year of Hurricane Katrina – caused an estimated $79-billion (U.S.) in damages.
The index, known as CHI, uses data from the U.S. National Hurricane Center to gauge a storm’s potential damage. It differs from the commonly-used Saffir-Simpson scale, which ranks hurricanes from 1 to 5 based on wind speed. (Hurricane Sandy is a Category 1 hurricane.)
Today there are three basic types of hurricane contracts; “events,” “seasonal” and “maximum.” Contracts based on “events” are tied to the total number of hurricanes during a season. “Seasonal” contracts are based on the total CHI points from all hurricanes in a season and “maximum” contracts are tied to the highest CHI achieved.
Here’s how a typical trade might work. A company seeking protection against a severe hurricane might buy a “maximum” contract corresponding to a CHI point range that would cause damage to the company’s finances. If a hurricane at that level occurs, the company receives $10,000 for each CHI contract purchased. If the hurricane doesn’t hit that level, the company gets nothing and the investor who sold the contract keeps the premium.
The market for these contracts is relatively small, but it has been growing in recent years as hedge funds and other investors look for alternatives to the stock market.
“There’s tons and tons of ways to [trade] it,” said Jeff Hodgson of Chicago Weather Brokerage LLC. Mr. Hodgson, who doesn’t actively trade hurricane futures, said one example of a possible trade would be an investor who takes a long position on gasoline futures and goes short on hurricanes by selling a contract – meaning the investor is betting a hurricane won’t happen. If a hurricane does happen at the CHI scale specified, the trader loses on that trade but makes money on the gasoline trade, since gas prices typically go up after storms as refineries are damaged and supplies cut.
“Right now [Hurricane Sandy] is a big event,” said Mr. Hodgson. “It’s not good for people in general, but for the hurricane market this is actually good because this is what drives people in [to the market].”