India Is Agricultural Based Economy

Published Date: 02 Nov 2017

India is agricultural based economy. India’s major GDP is depend upon agriculture and if there is bad monsoon than around 20% of GDP s wiped out which in turns affect the economy and financial market. Weather is very important production factor and at the same time it is one of the greatest sources of risk in agriculture. The uncertain global weather conditions particularly in 2010 had effected many businesses and industries especially commodities. Companies had to pay high prices on commodities due to rising prices and this effects the consumers & farmers too. Traditional Tools & techniques were the failure and have been unable to cope up with the unpredictable weather risk. This necessitates the need for Weather Risk Management in Indian Agriculture. Weather derivative is not only beneficial to farmers bur it can also be used in various industries like energy industry, construction industry, transportation, ski- resort, renewable energy, tourism, promotion, hydro electric power station, retailing, etc

In this report various challenges has been found which is the hurdle in the successful implementation of weather derivative in India. The challenges of weather derivative in India are-

1. Lack of Infrastructure

2. Lack of effective statistical model

3. Difficulty in collecting weather related information

4. High administration and implementation cost

5. Technically very challenging

6. Regulatory and legal Status

7. Lack of investors awareness and education

8. Institutional Concerns

9. Transaction Cost

10. Limited expertise

11. Image of weather derivatives.

12. Difficulty of pricing and valuing weather derivatives.

13. Delayed compensation

14. Local ownership

After the study it has been identified that there is vast opportunity of weather derivatives because:-

1. Weather conditions are unstable in India

2. There is lack of irrigation facility

3. India GDP is depend on agriculture

4. It is helpful in earning profits through speculative activities and it also create shareholders value

5. I t is also helpful in reducing government subsidies.

STATEMENT OF PROPOSAL

PROBLEM STATEMENT

Weather derivatives have been very popular in U.S.A. The major customer of weather Derivative is the utility companies but in Chicago Mercantile Exchange farmers started using the weather derivative. In India the major customers for weather derivative will be the farming community. We don’t see a huge potential for the derivatives by utility companies as India is a power shortage nation and we don’t see the chances of excess power due to cooler summers or warmer winters. The reasons why we think the weather derivatives will be success in India are

Farmers

Rs 2,31,798 crores were the agricultural credit in ninth plan

90% of the crop is at the weather related risk every year

Rural economy is also highly dependent on weather.

Commodity Traders

There is intraday volatility in products

Vegetable and fruit Mandis is also dependent on temperature

Traders’ income dependent on weather vagaries

Industries like agro-input companies, food processing industry, plantation, FMCG, Power sector depend on weather

INTRODUCTION

DERIVATIVE

Derivative is a financial instrument which is used to reduce risk. It is financial contract between two parties whose value is derived from underlying asset. There are many kind of derivative and they are swaps, option, commodity derivative, financial derivative, weather derivative, etc.

WEATHER DERIVATIVE

Weather derivatives can be used to hedge businesses which are exposed to weather variables. If the activity of a business is influenced by temperature, snowfall or sun, a derivative on the appropriate weather variable could be used to reduce revenue fluctuation.

For example, the owner of a soccer course might want to reduce revenue fluctuations caused by rainy days, or the owner of a snow resort want to hedge against the consequences of low snowfall, or a wine producer might find it useful to protect farm income against frost in grapes' flowering season.

Weather is always been a source of risk for many economic activities, but it was not until the late '90s that firms explored the possibility of hedging against weather related variability through weather derivatives. There was development in weather markets due to the deregulation of the US energy sector, when local monopolies had to compete in broader markets and to find measures to stabilize fluctuating revenues. Tradionally ordinary insurance and reinsurance tools were designed to target only catastrophic events, and they were very expensive and they were not even sufficiently flexible for ordinary risk management practices that focus on fluctuations closer to the mean of the distribution. Energy Traders were facing these many challenges so they started thinking of financial solutions for trading their exposure to weather risks within their own industry. The first move in this direction was the development of objective and reliable indices that could capture weather fluctuations in ways appropriate for hedging their economic exposure.

WEATHER DERIVATIVES IN AGRICULTURE

Weather Derivative work as a hedging tool for agricultural producers and for risk underwriters as weather event is a source of economic risk for agriculture. For the development of Weather Derivatives for agriculture the weather variables must be measurable, historical records must be adequate and available, and all parties involved in the transaction must consider such measures objective and reliable.

In addition, the existence of a complex relationship between the weather factor and the product must be carefully explored. In energy sector many weather derivatives are traded like derivatives on HDD, the relationship between demand and temperature for heating is simple and direct: the lower the HDD the lower the demand for energy. In case of agricultural production the relationship is not always simple and as straightforward since differences in products, soil textures, crop growth phases, etc. have different responses to the same weather factor. The entrepreneurial influence on yields will be greater if there is more advances and skilled cultivating technique. The smaller the portion of variability generated by the specific weather elements.

The development of Weather Derivatives in agriculture in India does not seem to be limited by the availability of adequate weather statistics, as many developed and developing countries have extensive and reliable weather data records. The problem in access to the data is both in terms of bureaucratic procedures and cost of purchase. Clearly, the easier the access to the data and the less expensive weather data, the more the opportunities for developing Weather Derivatives.

The crucial issue for the application of Weather Derivatives at the agricultural production level lies in the actual presence of a clear and satisfying relationship between the weather factor and the production variable. For the success of the Weather Derivatives it must be able to explain a very high portion of the variability in production otherwise it will loose its attractiveness as a hedging device. Hence it is very important to have appropriate identification of the relationship between production and the weather variable. This constraint is not as binding for the use of Weather Derivatives at the reinsurance level, since it can be used to retrocede the specific layers of the overall aggregate risk exposure that are triggered by the weather event. In addition, the smoothing effects generated in a portfolio of agricultural risk underwriters makes often easier to diversify the impact of a weather variable.

CHARACTERISTICS OF WEATHER DERIVATIVES

Contract structure

Weather derivatives are standardized contract and they are traded in stock exchange. All the contract details are structured and defined in advance only buyer and seller has to decide about the price of the contract in which they have to enter.

A structured contract contains following details:-

•Contract period: In contract period start date and an end date is defined, usually a month or a season.

• Measurement station: Weather stations are used for measurement of temperature and they are preferably close to the company's location to reduce geographical basis risk.

• Weather variable: They are corresponding to weather exposure and hedging needs.

• Underlying: index which aggregates the weather variable over the contract period

• Payoff function: It determines the cash-flows of the derivative.

• Strike level: value of the index at which the payoff changes from zero to a non-zero value

• Tick and Tick Value: defines how much the payoff changes per unit of the index that is how much there will be increase in price with the increase in per unit of temperature or any other weather variable.

3. TERM

However, volume of trading is observed higher in one month and one week contracts as the markets have grown. In these contracts variable index calculation procedures is also specified within the overall term - such as exclusion of weekends or double weighting on specific days - to address individual end-user business exposures.

4. PREMIUM

The buyer of a weather option contract is a called holder of the contract and he has to pays a premium to the seller.

5. MECHANICS OF TRADE

They are calculated as follows:

HDD = Max (0, 65° F minus average temperature in a day)

CDD = Max (0, 65°F minus average temperature in a day)

The threshold temperature for CDD and HDD has traditionally been 65°F. The reason is consumers tend to use more energy to heat their homes when the temperature is below 65°F and when it is above 65°F, they tend to use energy on cooling.

TYPES OF WEATHER DERIVATIVE

WEATHER FUTURES

Futures contract is an agreement between two parties to buy and sell an asset at a specified time in the future for a predetermined price. Futures contracts are always traded on the exchange and the parties entering into to the contract do not know each other. There is no counterpart risk as the exchange also provides a mechanism and a guarantee that the contract will be honored. The Chicago Mercantile Exchange (CME) provides a platform for trading in weather futures which is based on the on the CME Degree Day Index, which is a cumulative sum of the Heating Degree Days (HDDs) or Cooling Degree Days (CCDs) during a single calendar month, as well as provides options on these futures . For example if the notional value of futures is $100. So, a temperature index of 750 would mean the futures contract has a notional value of $75,000 (750* $100).

WEATHER SWAPS

A weather swap is a contract in which the two parties exchange each other’s risk during a predetermine period of time is known as swaps. In swaps one party has a fixed position while other take variable position that is one party to the contract pays a fix set of amount whereas the other side pays a variable price. For weather swaps the contract period is often defined as one calendar month or period such as January to March. The swaps is very similar to a forward contract as there is only one day when the cash flows are swapped as compared to an interest rate swap which has several swap days. The simplest kind of weather derivative is the uncapped swap in which payoff is a linear function of the weather index. A weather swap contract is formulated by the help of two important parameters. The two parameter are the strike level which is in the form of a weather index, if the weather index is measured during the period of the contact has a value which is larger than the strike level then the sellers of the contract will pay the buyer an amount that is proportional to the difference between the weather index and the strike, and vice versa. The constant of proportionality is usually determined with the help of strike level. The second parameter is its tick. Whereas weather swaps are concerned they are usually not linked to any kind of premium (Jewson, 2004a).

Swaps as futures, which are usually uncapped are traded on the Chicago Mercantile Exchange. All the exchange traded swaps are based on the daily temperatures, which are then converted into monthly and seasonal settlement index, which differs from region to region. The weather swaps are traded on 21 different locations on the CME; they are 15 in the United States, 5 locations in Europe and only 1 in Japan. To create a settlement index in the US both the heating and the cooling degree days are summed across a specified period of a weather contract. Whereas Europe is concerned the only difference is that the daily temperature is summed across the period of the contract directly. While in Japan, monthly or a seasonal index is shaped as the average temperature across the period of the contract (Jewson, 2004).

WEATHER OPTIONS

Weather Options are traded on the exchange as well as in over the counter (OTC) market. There are two types of option that is a call option and a put option. A call option gives the holder of the option a right to purchase but not an obligation to purchase an underlying asset on a particular date at a certain price. On the other hand a put option gives the holder a right to sell an underlying asset on a particular date at a certain price. The price of the contract is known as, the exercise price or the strike price of the option and the date on which the contract is exercised is known as maturity or expiration date.

There are major two types of option

1. An European option which is exercised only at the time of maturity

2. American option can be exercised anytime up to maturity

WEATHER LINKED BONDS

Weather linked bond is defined as a debt instrument in which the issuer of the bond has to repay the sum borrowed along with interest to the investor at the time of maturity. In the case of weather bonds the coupon payments is always dependent on the occurrence of a particular weather event that is the amount of coupon reduces when a particular event occurs and the bondholder receive a lower amount than it would have received if the particular even had not occurred. However the principal amount s assumed not to be risky.

Weather linked bonds are very much similar to the catastrophe bonds. Catastrophe bonds are used by firms to insure themselves against losses caused by extreme weather events such as floods, hailstorms, hurricanes etc. Whereas weather linked bonds are issued to spread risk and would it would also attempt to protect the business against natural catastrophe. It would also protect the business against loss done to the volume of their earnings and sales due to changes in weather conditions.

PRICING OF WEATHER DERIVATIVES

A right pricing model is very important for a successful trading market. A derivate contract derives its value from the underlying asset like in case of weather derivative contract the underlying asset is weather variable like rain, snow, temperature, wind. This makes it difficult to price weather derivative contract. After reviewing the agricultural industry it has been found that every grain has a drop of water in it and that drop of water is like life blood for farmer and that drop of water is traded. So the value of the grain is derived from the drop of water hence, whatever is the value of the grain is the value of the weather. Therefore it can be said that weather is deriving its value from the underlying commodity it is affecting. For example, the type of weather risk faced by weather is the underlying value of rice.

The pricing models are as follows:

Black - Scholes model

The Black-Scholes model is considered as one of the most appropriate and successful method in pricing derivatives. Under this method, one creates a portfolio that correctly replicates the pay off of a derivative contract (Young and Zariphopoulou, 2002).

This model for pricing options holds true under certain assumption which are, one can trade an asset without involving transaction cost. The second assumption is that asset price is not influenced by the trading of the asset which is undertaken to hedge the option

DIFFERENCE BETWEEN INSURANCE AND WEATHER DERIVATIVE

Insurance

Weather Derivatives

Meaning

It is a type of protection against financial losses that can be caused due to snow, rain, fog or undesirable temperature or other measurable weather condition.

Weather Derivative is a contract whose value is derived from underlying assets like in this case it can be rainfall, snow, temperature etc.

Purpose

Insurance is not a tool to make money but a tool which helps a business or individual to compensate for an unexpected loss which would otherwise result into a financial disaster

It is used for hedging purpose that is to minimize the losses and it is also a tool to make money.

Payoff

To claim the loss, the holder of the insurance contract must prove that a loss has occurred due to changes in weather conditions

In weather derivative the payoff is depend solely on the actual outcome of the weather and it does not consider the effect it has on the holder of the weather derivative contract.

Insurable interest

In insurance contract buyer need to have insurable interest that is buyer need to have weather sensitive production.

Weather derivative need not to have an insurable interest that is to enter into a derivative contract one need not have any weather sensitive production.

Speculation purpose

It cannot be purchased for speculation purpose.

It can be purchased for speculation purpose.

Advantage

Insurance only cover limited variable and it is limited to certain conditions.

weather derivative contract are used whether the winters are warmer or the winters are colder than it was expected , the derivative market can meet the needs of both and the participants and hedge each others risk through a derivative contract

Accounting and tax treatment

Premiums typically expensed over policy life and recoveries are not typically a taxable gain

It is treated as an investment and typically valuated using mark to market and recoveries generally create a taxable gain

Liquidity

Illiquid, effectively a buy and hold instrument; Coverage is non-cancelable

Greater liquidity than insurance, standard contracts are traded on an exchange, not necessarily a buy and hold instrument

Regulatory Controls

Significant, including state insurance commissioners

Currently minimal, sold in many cases under exemptions recognized by the Commodity Futures Trading Commission

BENEFICIARY OF WEATHER DERIVATIVES

Energy Industry

They take weather derivative to hedge changes in temperature as during warm winters and cool summers their sales will decrease so they want to minimize the loss they face due to decrease in their revenues.

Energy consumers

They are interested in weather derivative to hedge against changes in temperature as there will be higher heating cost during cold winters and high cooling cost during hot summers and customer wants to get relief from energy cost burden by taking temperature weather derivative.

Beverage Producers

As beverages are usually consumed in summer season and if summers are not as hot as expected or temperature is not suitable for in taking of beverages by customers than sales of beverages will fall and beverage industry will suffer losses due to changes in temperature so here temperature based weather derivative will help them to recover them from their losses.

Building Material companies

The changes in temperature as well as rainfall can adversely affect their business as there will be lower sales during severe winters or in case of heavy rainfall. Weather derivative having underlying asset as temperature and rainfall is helpful for them.

Construction companies

In this case company can be affected due to poor weather as there will be delay in meeting schedules during bad weather so they want to have weather derivative which can safeguard from changes in temperature and rainfall. Many times payoffs in construction projects are related to timing (early completion bonuses, late fees etc.). However, the weather could well thwart construction companies’ plans to finish projects in time. Thus, the construction industry might want to consider hedging its exposure, ensuring profitability at all times.

Ski –resort

There will be lower revenue during winters having below average snowfall so weather derivative is also helpful for them.

Agricultural industry

Every farmer knows that the quality as well as quantity of crop is primarily determined by the weather. Even though the market place creates unintentionally a certain cushion (bad weather empirically also comes along with higher crop prices, reducing the impact of the weather on the bottom line), the agricultural companies remain immense towards weather exposure. Through structured weather solutions that are weather derivatives farmers could decide to significantly reduce the risk associated with climate variables, thus ensuring the long-term success of their entity as farmer’s crop loose due to extreme temperature or rainfall so derivative can save them from loss.

Municipal Government

High snow during winters with above average snowfall can increase their cleaning cost so weather derivative is also helpful for them

Hydro electric power generation companies

A hydroelectric plant can manage their exposure to precipitation to prevent any risk associated with low energy generation.

Entertainment

We have witnessed that attendance in shows or in entertainment is dependent upon weather variable like temperature, rainfall etc. Events are always planned and organized well in advance so financial success of the events is somewhat arbitrary so organizer can minimize or even eliminate the weather risk by taking weather derivative.

Insurance

Insurance company can use weather derivative to increased claims and diversify premium.

Offshore

Storm frequency and severity can affect their business so weather derivative is also helpful for them.

Retailing

A retail sector entity wants to know about the weather variable as the store revenue is depend upon the weather variable and use this information to temporarily adjust prices as well as the supply chain accordingly.

Transportation

Due to heavy rainfall or fog due to severe winters can delay the transportation of goods which overrun their transportation cost so they can also take the benefit of weather derivative.

Renewable Energy

Wind park investor wants to hedge the risk of low windiness throughout a pronounced period of time. By hedging the wind exposure, wind park investors can ensure the stable cash flows, helping them to reduce the cost of capital as well as enabling them to use higher leverage.

Tourism

A company those who are managing recreational parks should be concerned about the impact of meteorological variables on the number of visitors and revenues. This would allow them to reduce operational cost (e.g. through a better management of part-time personnel) as well as to minimize the weather impact in essential periods (e.g. holidays, weekends etc.)

NEED FOR THE RESEARCH

India is a huge country which is agricultural based and major source of income for majority of population comes from agriculture. 60% of population is dependent upon agriculture or agro based industry Even in regions of India which have good irrigation facilities, monsoon rains are beneficial for crops and rainfall helps improve yields of crops. Getting only rain doesn't help Indian farmers instead they have to look after the quantity of rains , enough rain or less rain both the way they have to face the problem. If there are heavy rains then flood comes and take away all their hard work. If there is less rain then drought like situation comes and ruined their life. Sometimes it's very hard for them to come up fresh again after so much of loses.

OBJECTIVE OF RESEARCH

To identify the challenges and opportunities of weather derivative in India

To identify the hurdles in the evolution of weather derivative in India.

To develop a suggestive framework for effective implementation of weather derivatives in India

RESEARCH METHODOLOGY

RESEARCH DESIGN

In this study case based research is used. This research design is opted to explore the benefits and opportunities of weather derivative in India.

DATA COLLECTION

To carry out the study, I will use primary as well as secondary source to collect data.

Primary data:

Primary data has been collected through from experts through interview and personal interaction

.

Secondary data:

Secondary data from various websites and research papers have been used to collect data to know in-depth about weather derivatives.

SAMPLING DESIGN

In this study I have used non probability sampling method to collect data. I have opted for convenience sampling that is the cases which are easily available on electronic media.

WEATHER DERIVATIVE IN INDIA

There is another sad story about bad monsoon in India is that farmers earn less money and get in to debit later can't be able to pay back even small amount which a rich man spent in the five star hotel in a day.

It's very sad that those who prepared crop and give us to eat do not have enough support from government. May be this is the reason they takes extreme action towards life and commit suicideSo far total monsoon rain fall in our country is about 22 percent which lower than average and it has made the drought like situation. Where bore-wells and canals available those farmer who can afford fuel-diesel pumps are trying hard to save their crops. Elsewhere many farmers have reduced their farming.

The bad monsoon will not only affect the farmers but also the common people life and budget because monsoon directly affects the cost of food products which we eat. It effects the overall production of our country and because of that the price for every food item will get higher

Hence it is most likely that weather derivatives in India should have the monsoon or rainfall as their underlying. It is also based on the way that normal derivatives are traded on the exchange.

Weather trading in India has a bright future. Until and unless the bill is not passed weather trading will be a dream on intangible assets like rain, temperature. In India bad monsoon affects the production of the country due to this poor farmer’s grief and opt for suicide in some places of India, Country’s GDP and also stock market. Taking all this into consideration along with issues of Global warming we can appreciate what crucial role weather has to play in India. If we knew how the weather was going to behave in the future, there would be absolutely no basis for the existence of tools which make it possible to improve and stabilize results against the backdrop of changeable weather conditions. But we can lower or Hedge the risk through weather derivatives. In India temperature derivative can easily be traded as in India 90% of the weather market comprises of the agricultural sector so the weather index that is going to be launched in India is going to be a temperature and well as precipitation.

Weather Derivative still not has been introduced in the Indian Market. With the recent amendments to the Securities Contract Regulation Act, derivatives trading are allowed in commodities that was earlier banned but trading in weather derivatives has not even receive a formal nod from the government.  The bank is selling weather derivatives as an over-the-counter product to companies whose operations are significantly dependent on weather conditions.  ABN Amro Bank is exploring sales of weather derivatives and catastrophe bonds for the first time in the country.  The bank is talking to companies in the beverage and cement sectors, to airlines and oil majors to get the benefit of weather derivative.

EFFORTS DONE TO PROTECT FARMER

Index based weather insurance to groundnut farmers

In 2003, Hyderabad-based micro-finance institution BASIX and Mumbai-based insurance company ICICI Lombard, with technical assistance from CRMG, launched their first pilot program for index based weather insurance in the Mahahbubnagar district of Andhra Pradesh. This pilot program sold weather insurance policies to 230 groundnut and castor farmers protecting against deficit rainfall. After 2003, BASIX tried to improved the weather insurance products based on farmer feedback and also trained their loans officers as customer services agents. As a result by 2006, BASIX sold rainfall and multi-peril weather contracts including temperature and relative humidity to over 11,000 customers in all states in India and have continued to expand their weather insurance client base. While BASIX’s and ICICI’s product innovation and expansion of the program is notable, their work also catalyzed the weather insurance market in India.

Various insurance companies selling weather insurance to farmers

Since 2004, four insurance companies have sold weather insurance policies to farmers and they have insured Indian weather risk into the international risk markets.

Installation of Weather stations

In 2005 a private sector company in India began the installation of over 400 automatic weather stations to complement the Indian Metrological Department’s network and to support market growth.

PepsiCo contract farming program me in India

They have launched the Program to protect potato farmers from late blight disease and weather index is temperature and humidity

DUMMY TEMPERATURE BASED WEATHER DERIVATIVE CONTRACT

Crop

Rice

Reference Weather station

Hoogly District

Index

Temperature

Risk Period

1 April to 31 July

Base temperature

23 degree Celsius

Maximum temperature of Hoogly

45 degree Celsius

Minimum temperature of Hoogly

5 degree Celsius

Average temperature

25 degree Celsius

Payoff

Rs 1000 per degree day

HDD = max (0, Base temperature - T)

Where;

T= the average of the high low temperature of the day

CDD = max (0, T – Base temperature).

In this cooling Degree day temperature is

Max(25-23)

CDD= 2

The holder would have a pay-off of 10,000 times 2 or Rs 20,000 in the case of a CDD contract. The rationale is that the buyer of such a derivative would be compensated by the amount for which his cash flows are adversely affected by the weather.

OPPORTUNITY OF WEATHER DERIVATIVE IN INDIA

Opportunities of Weather Derivative in India

Even in our advanced technology based our society is still live largely at the mercy of the weather. It influences Indians daily lives and choices, and has an enormous impact on corporate revenues & earnings. Until recently, there were very few financial tools offering companies protection against the erratic nature of the weather.

Adverse Weather conditions resulting in higher than normal pest infestation or disease outbreak in plants.

Adverse weather condition can creating water imbalance that affects the photosynthesis process of the plant resulting in decline in crop yields in a rain-fed area.

There is lack of participation from private sector in agriculture insurance whereas insurance is based on the concept of "risk pooling". This implies that insurance spreads risk among the policy holders having less than perfectly correlated risks or uncorrelated risk. Thus, the insurer diversifies non-systemic risks across the insurance pool.

The failure of crop insurance scheme is the biggest opportunity for the weather derivative in India. The reason for the failure of weather derivatives are:-

They failed in correctly estimating the probability of risk covered.

The total claims disbursed were excess of the premium collected

The government decision to phase out the subsidy on insurance premium and due to this the scheme is acceptable to the larger farming community.

These schemes involve very high administrative expenses.

There were delays in the settlement of claims.

Government burden of subsidies can also be reduced as farmers losses can be covered by weather Derivative.

Indian agricultural industry is highly dependent upon Monsoon rainfall. Only 40% of cultivated lands have access to irrigation and only 20% of the land is effectively cultivated. About 80% of land is depending on rainfall.

Weather Derivative is also a blessing for Indian agricultural industry as agriculture contributes about 24% of the Indian GDP. Livelihood support to two-third of the population in India.

Weather derivative is helpful in protecting profits of agricultural industry, energy industry, construction industry, tourism and many more.

Weather derivative is also helpful in creating values for shareholders.

Agricultural loans are very risky and farmers even commit suicide due to the burden of debts.

Investors can also earn profit from weather derivative transactions if nothing extraordinary weather-wise occurs. If the weather goes bad, the company that bought the derivative collects an agreed-upon amount.

Weather Derivative is also helpful in the growth of economy and this is explained in following flow chart:-

CHALLENGES OF WEATHER DERIVATIVE IN INDIA

INFRASTRUCTURE

For the effective weather derivatives it is necessary to have secure, dense and high quality weather stations network with clean and consistent internal historical records. A secure, dense and high quality weather station means that:-

a) Weather derivative can be easily indexed to the weather stations monitoring weather conditions that are representative for clients so that basis risk is reduced.

DESIGNING AN EFFECTIVE MODEL

Challenges in using weather derivative as a cross-commodity hedge is in deciding the effective yield model risk which should be helpful in determining the fraction of risk that can be easily hedged using weather derivatives. This problem is not limited to few derivative contracts like power and gas but in agricultural markets, common wisdom suggests that weather derivatives could be used to hedge yield, but not price. Effective statistical models should be developed to couple weather risk to agricultural price risk. Great care should be taken to determine the effectiveness and quality of the model.

DIFFICULTY IN COLLECTING WEATHER RELATED INFORMATION

The company has to rely on historical weather related data which is not effective for designing weather derivatives as weather conditions are changing continuously due to increase in pollution, global warming so it is not a wise decision to design weather contract based on historical data.

Companies are also facing challenge to build a diversified book, so the agricultural risk is spread across different kinds of geographical areas, different weather conditions and different time periods.

HIGH ADMINISTRATION AND IMPLEMENTATION COST

The cost of weather derivatives is made up of two components. First, the underlying risk is based on the severity, frequency, and extent of impact of loss which is known as pure risk.

Second, the large cost is also involved in administering and implementing weather derivative mainly individual risk assessment and loss adjustment. Together, specifically in agriculture, these costs are very high and premiums are excessive for farmers. So farmers feel very costly to buy weather derivatives.

TECHNICALLY VERY CHALLENGING

The technical nature of weather derivative makes it expensive to develop indexes and it is also difficult to market these derivatives to customers. It is very difficult for the customer to understand the concepts and implication of weather derivative and situation become worse when it comes to understanding of mathematical modeling, crop phrenology and mathematical modeling.

REGULATORY AND LEGAL STATUS

The worst thing is that certain commentators have referred to these derivatives as amounting to little or more than gaming or lottery type activities. and designing of standardized contracts, attractive pricing mechanism and construction of appropriate weather based Indices also require the support of strong regulatory infrastructure. Moreover support from Forward market Commission (FMC) and SEBI to permit derivative trading on underlying assets like weather parameters, etc. In the current scenario SEBI regulates cash and derivative market on exchanges of all securities (i.e. stocks and bonds) while FMC regulates Commodity forwards and futures which has a back of the government department and it has no autonomy to garner resources. In addition Ministry of Company Affairs, Ministry of Agriculture, and the Reserve Bank of India also exercises direct or indirect regulation over securities and commodity trading. These major complexities in Indian regulatory jurisdiction and multiplicity of regulators may pose regulatory challenges so there is the need for establishment of an independent regulatory body acquainted with adequate resources and empowerment regulating the weather derivative market. The Forward Contract (Regulation) Amendment Bill 2006 is still pending with the parliament which aims to consider trading activities more efficient and also seeks to transform the role of the Forward Markets Commission (FMC) from a government department to an independent regulator like Securities and Exchange Board of India (SEBI). There is also a need to broaden the act so as to permit trading on intangibles like weather parameters, electricity, etc.

LACK OF INVESTORS AWARENESS AND EDUCATION

Client/stakeholder education or farmer education is essential to establish successful weather derivative programs in India. Lack of understanding of derivatives can lead to dissatisfaction with the program and resistance to derivative purchase and growth and depth of weather derivative cannot be achieved without investors awareness and training. For any new derivative product like currency derivatives, interest rate derivatives various awareness programmed and campaigns had prove to be successful for educating and training of farmers, consumers, financial intermediaries, etc . There is need to develop the customer confidence on workability as well as transparency of the weather derivatives among the farmers in a newer product is of utmost importance. It is also needed to adequately educate other stakeholders from public as well as private sectors who will be involved in the management of the weather derivatives. Due to the limited knowledge regarding hedging instruments issues such as tax, accounting and legal treatment of derivatives, could be perceived as challenging

INSTITUTIONAL CONCERNS

Trading in weather Derivatives requires infrastructure support in terms of Creations and support of Exchanges, Consumer Associations, Weather observatories and Clearing and Trading Members for Trading to remove the demerits of over the counter. National Stock Exchange is currently trading currency derivatives and NCDEX & MCX in commodities derivative contracts. These can also be used for trading weather derivative. Through Exchanges a large number of customers can be targeted .Also Exchanges are more safe as they will provide more transparency and will provide safe and secure trading platform to small farmers. Various associations could be set up for accessing markets by farmers. The crucial factor is to provide accurate, timely, reliable data (on weather parameters, crop yields and power production and consumption) to all concerned parties.

TRANSACTION COST

The term transaction cost refers to direct trading costs, (e.g. brokerage fees, weather data) which is incurred in a typical weather derivative transaction. Instead, a stand-alone weather derivative with a straight up front premium has to be paid before the protection period is generally concerned for analysis. Based on the structure, end-users would enter directly into a contract with a weather derivatives seller without further intermediaries. The high proportion of fixed costs results in minimum contract volumes and that cost is too large for the farmers. The resulting high up-front premiums will probably dissuade small farmers from hedging, especially when the volume to be hedged is relatively insignificant. The company can go for bundling schemes to reduce transaction costs. Through bundling schemes, different companies located in different regions can share a derivative contract to achieve a reasonable volume and to distribute the fixed costs over the pool of users. If the risk management needs of these firms are dealt with by a joint association, the transaction costs for the weather derivatives provider can be much lower than when dealing on individual basis. This could also reduce the option premiums to an amount affordable for small farmers. Further, very standardized contracts can be an alternative to reduce transaction costs

LIMITED EXPERTISE.

Due to the lack of institutional framework is the limited expertise in hedging. This factor is assumed to be have a major impact, as knowledge is one of the basic prerequisites risk management of risk In India people dealing in weather derivatives lack the necessary skills regarding the implementation of weather derivatives. There is also a lack of information on the actual use of the weather derivatives markets (e.g. finding counterparties), so they are less likely to access the market. Moreover, the identification of institutional deficiencies which results in inadequate risk reporting and evaluating mechanisms, makes it difficult for management to obtain the relevant information for applying hedging instruments even if they knew them. This also impedes an efficient adaptation of hedging strategies.

IMAGE OF WEATHER DERIVATIVES.

Weather Derivate instruments are often perceived as complex financial instruments by the public. Unfortunately, public do not address the potential positive risk management aspects, weather derivatives are in public sometimes discussed in a context of gambling or betting, as their mode of operation is not understood. Hence, weather derivatives also carry a negative image and are perceived as speculative instruments. Hence this negative image can hinder the application of weather derivatives since decision makers rely primarily on outside information due to their limited derivatives expertise.

DIFFICULTY OF PRICING AND VALUING WEATHER DERIVATIVES.

There is lack of a standardized pricing model for weather derivatives which may have a negative impact on their usage, as this complicates the comparison of different contracts for potential customers.

DELAYED COMPENSATION

One of the major hindrances in the development of the weather derivative market in India is lack of availability of reliable weather data and also the main reason for the delayed compensation of claim where weather derivatives is concerned are-

Data Deficiency

• Delay in Current Data

• Lack of quality Historical Data

Product Inefficiency

• Improper Risk Assessment

• Regulatory Restrictions

• Historical yield / production / sales data

• Low Landholdings in case of agriculture

Inefficient Outreach

• Weather Information

• Farm Management

Customer / Risk Profile

• Large share of Rainfall Risk

• Single side Risks

• Major buyer segment is uneducated and ignorant about weather High Risk Transfer Cost

• Impacts Penetration Levels

LOCAL OWNERSHIP

It is necessary to have the local ownership for the effective launch of weather derivative in small agricultural state as people can easily connect with local people but in India it is difficult to have ownership of local people as nobody in India wants to invest in new business. If the program is locally designed and owned than this will help to ensure that programs can become self-sustaining and evolve with local knowledge and capacity to suit the needs of the local market.

CONCLUSION

The initial of weather derivatives has been traced in the beginning of the extremely warm winters of 1997 which was later enhanced by the deregulation in the electricity markets. The energy company such Enron initiate and promote constant innovation and analysis on various ways to mitigate risk in order to earn stable revenues. However the collapse of Enron increased the development of OTC trading in the CME and first weather derivative is launched in Chicago Mercantile Exchange.

Indians economy is depending on agriculture and agriculture is depending on weather conditions. However India has already launched weather insurance but the concept of weather derivatives is new and just a matter of research. It is not only the agriculture industry but also energy and power industries, insurance, tourism, and retail businesses are all in some way directly or indirectly affected by weather.

In the research the main focus was to analyze the developing weather market in India and to find out the opportunities and challenges of weather derivative in India and how the farmer’s life can be improved by overcoming the challenges and adopting weather derivative.