Introduction to Derivatives
This problem offers different scenarios in which some companies may have an interest to hedge
their exposure to temperatures that are detrimental to their business. In answering the problem, it
is useful to ask the question: Which scenario hurts the company, and how can it protect itself?
Asoft drink manufacturer probably sells more drinks when it is abnormally hot. She dislikes
days at which it is abnormally cold, because people are likely to drink less, and her business suffers.
She will be interested in a cooling degree-day futures contract, because it will make payments when
her usual business is slow. She hedges her business risk.
A ski-resort operator may fear large losses if it is warmer than usual. It is detrimental to her
business if it does not snow in the beginning of the season, or if the snow is melting too fast at the
end of the season. She will be interested in a heating degree-day futures contract, because it will
make payments when her usual business suffers, thus compensating the losses.
During the summer month, an electric utility company, such as one in the South of the
United States, will sell a lot of energy during days of excessive heat, because people will use their
air conditioners, refrigerators and fans more often, thus consuming a lot of energy and increasing
proFts for the utility company. In this scenario, the utility company will have less business during
relatively colder days, and the cooling degree-day futures offers a possibility to hedge such risk.
Alternatively, we may think of a utility provider in the North-East during the winter months, in
a region where people use many additional electric heaters. This utility provider will make more
money during unusually cold days, and may be interested in a heating degree-day contract, because
that contract pays off if the primary business suffers.
An amusement park operator fears bad weather and cold days, because people will abstain
from going to the amusement park during cold days. She will buy a cooling-degree futures to offset
her losses from ticket sales with gains from the futures contract.
A variety of counter-parties are imaginable. ±or one, we could think about speculators who have
differences in opinion and who do not believe that we will have excessive temperature variations
during the life of the futures contracts. Thus, they are willing to take the opposing side, receiving
a payoff if the weather is stable.
Alternatively, there may be opposing hedging needs: Compare the ski-resort operator and the soft-
drink manufacturer.The cooling degree-day futures contract will pay off if it the weather is relatively