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Severe flooding and extreme heat caused havoc for much of Europe in 2007, whether in Tewkesbury, England, or the Peloponnese region of Greece. But did the financial markets anticipate this pattern of unusual weather better than they did the tide of subprime mortgage blow-ups in the US?
If the markets timed it right, for example through bundling up projected revenue, earnings and insolvency risk in the form of weather derivative contracts, or exposure to catastrophe (cat) bonds, then weather, as an investable asset, delivered.
Hedge funds and investment banks claim the most aggressive returns, the former entering the weather trades market early (it is only about 10 years old).
Hedge funds spotted that money could be made from what was fundamentally a tool for energy companies to mitigate risks and a way of protecting against losses from hurricanes, floods and frost - or, in the case of Greek farmers last summer, scorched olive trees. The size of the weather derivatives market notched $35 billion (23.7 billion euros) in 2007, based on the maximum potential payout on futures contracts written globally. In 2002, it was just $2.5 billion.
"Even three years ago, few investors understood the extent to which weather drives the financial markets," says Peter Brewer, chief investment officer at Cum-ulus Funds, a hedge fund that has attracted $250 million, including $150 million in its Cumulus Weather Fund, and returned 34 per cent since its 2005 debut.
Options
"Participating in the weather derivatives market is actually very simple," he says. "Anyone who believes London will be hot in May can buy London May futures on the Chicago Mercantile Exchange. However, identifying profitable opportunities is somewhat harder."
This year Cumulus launches an agriculture fund, applying knowledge of the weather to trades made on agricultural commodities.
Tradable investment benchmarks, such as the Greenhouse Index launched by UBS this month, provide investors with a simpler route to the upside of weather. "Because our clients were seeking truly uncorrelated alternative asset classes for div-ersification purposes, we decided to expand our offering to weather and carbon. As we felt that we needed to do this in a simple and transparent way, the solution [was] an index format," says Ilija Murisic, head of hybrid derivatives trading at UBS. Its Global Warming Index, launched in May 2007, has generated $100 million and returned 53 per cent.
It was Hurricane Katrina - one of the deadliest and costliest hurricanes in US history at about $65 billion in damages - in 2005 that triggered a crucial change of perspective towards weather as a tangible investment.
"Weather is now in an asset class of its own," says Rene Huck, associate director for sales and marketing at the CME. The exchange has weather contracts based on city-focused temperature indices in the US and Eur-ope, as well as hurricane futures and frost futures. Users are predominantly "hedgers", but this has widened. "Our first participants were insurers, weather traders, hedge funds and commodities, purely because they needed diversification," says Huck. "But now trades are increasingly being made by equity portfolios that hold companies impacted by weather."
The Katrina effect also brought the financial risks of insuring against catastrophe to the fore of the capital markets and it was post-Katrina that activity in the cat bond market, which has had $12 billion of accumulated issuance since the mid-1990s, ramped up.
As with investing or trading in weather derivatives, the upside to cat bond investing is the non-correlation with assets such as equities or bonds. "The investor story is the same, though weather risk is closer to the money," says Dan Ozizmir, managing dir-ector at Swiss Re Capital Markets.
Swiss Re holds catastrophe risk and also manages its own insurance book for hedging purposes, in addition to writing weather derivatives contracts. Basically, catastrophe risk is more concerned with insolvencies, weather risk more with revenues.
"For investors, cat bonds are a great tool for diversifying your portfolio and, importantly, [are] not correlated to subprime," says Ozizmir. And non-correlation is playing strongly in the market because of the current credit environment.
Exposure
Hedge funds still make up two-thirds of cat bond buyers, though recently some pension fund money and fixed-income managers such as Pimco have sought exposure to event-driven notes.
Swiss Re launched a cat bond index last July, tracking a basket of US-denominated bonds.
Judy Klugman, head of cat bond sales and distribution at Swiss Re, says that as long as the supply of issuance continues at 2007 levels, investors' high expectations will be met. "We're very bullish," she says.
Industry sentiment concludes that bad news on subprime may in fact translate as uplift for the market in the long run.
"While the rest of the market is under pressure on pricing, spreads on cat bonds have tightened by 40 per cent in a year," says Klugman. "The light may be going off for credit investors, but not for cat bonds."
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