ISBN: 0-03-028931-9

Chapter 18 Derivatives and Risk Management

Bombardier Inc., a Montreal-based manufacturer of snowmobiles, has always tried to control risks. However, snowmobile profits depend on a risk that is notoriously hard to control: the weather. Early signs of a cold, snowy winter lead to a brisk sellout, whereas warmer temperatures force Bombardier Recreational Products to put in place sales programs to stimulate the market in order to dramatically cut prices in order to shed excess inventory.
While Bombardier can't change the weather, it has done its best to manage its weather-related risks. For example, the company recently offered to pay a $1,000 rebate to snowmobile buyers in 16 Midwestern cities if the area snowfall that winter turned out to be less than one-half the average snowfall over the previous three years. The rebate offer had a strong, positive effect on sales – in those 16 cities, Bombardier saw a 38 percent increase in its Ski-Doo Snowmobile sales over the previous year.
In addition, Bombardier took another important step to limit its risks – it bought "snowfall options" from Enron Corporation, a major natural gas supplier. For each snowmobile sold, Bombardier Recreational Products paid Enron between $45 and $400, depending on the city in which the snowmobile was purchased. In return, Enron fully reimbursed Bombardier Recreational Products every time it had to pay a customer the $1000 rebate.
These snowfall options are just one example of "weather derivatives," a small but rapidly growing market that Enron has helped develop. Until recently, weather derivatives were exclusively traded in the over-the-counter market, and the participants were primarily electric and gas utilities whose earnings would suffer if there were a milder than expected summer or winter. Just recently, though, the Chicago Mercantile Exchange (CME) established the first weather-based futures contracts. These contracts were based on the average monthly temperature in four U.S. cities: Atlanta, Chicago, Cincinnati, and New York.
Like all future contracts, each weather contract has a buyer and a seller. One side bets that monthly temperatures will be higher than expected, while the other side bets the weather will be relatively cold. For example, an Atlanta-based ice cream maker might purchase a weather derivative contract that pays off if summer temperatures in Atlanta are lower than expected. By doing so, the profits from its weather derivative position serve to offset the decline in ice cream sales due to cooler temperatures.
The initial response to the CME contract has been fairly lukewarm. However, CME executives, who estimate that 20 percent of the U.S. economy is sensitive to the weather, expect trading in these contracts to increase over time as businesses learn more about them.
Weather derivatives represent just one of many approaches companies can use to control risk. As you read this chapter, try to answer these questions: Why should a company try to manage its risks? What financial techniques can be used to manage risk? Can programs designed to limit risks actually increase them, and if so, what safeguards should companies put in place to prevent this unintended consequence?

DISCUSSION QUESTIONS

1. What is you opinion of the "weather option" discussed above? Would you ever consider investing in them for purely speculative motives?
2. What danger do you see with investing in derivatives for purely speculative reasons?

Return to Chapter

Copyright © Harcourt College Publishers, A Harcourt Higher Learning Company. All rights reserved.