Hurricane futures and options set to make waves at Merc

Articles, Medill Reports

Published by Medill Reports

By Christina Maria Paschyn
Feb. 14, 2007

Chicago will soon be trading in hurricanes.

The Chicago Mercantile Exchange Holdings Inc. (CME), announced Wednesday it will expand its weather derivatives product line by trading hurricane futures and options contracts.

The contract will allow insurance companies and other customers, such as energy companies, pension funds, state governments and utility companies, to hedge against the risk of hurricanes striking the United States.  Five storm-prone areas would be covered: the Gulf Coast, Florida, the southern Atlantic coast, the northern Atlantic coast and the eastern seaboard.

“Following the devastating 2005 hurricane season that caused an estimated $79 billion in damage, it became apparent that there was limited capacity to insure customer claims,” said Felix Carabello, CME Director of Alternative Investment Products. “With these hurricane contracts, insurers and others will be able to transfer their risk to the capital markets and thereby increase their capacity to insure customers.”

The CME-Carvill Hurricane Index (CHI) will be calculated by Carvill Group, a reinsurance intermediary that tracks and calculates hurricane activity.  It will begin trading on March 12.

“The challenge was to develop an index that meets the needs of both the derivative trading community and the insurance market,” said Dr. Steve Smith, Senior Vice President of ReAdvisory, the analytical arm of Carvill.  “Most importantly for the trading community was the requirement that the index could be calculated and settled within hours of an event taking place.”

Using data from the National Hurricane Center, Carvill calculates potential damage based on a storm’s size and maximum wind velocity.  The contract expires when a hurricane makes landfall. Investors are then paid based on the value of the CHI index at that time.

In the aftermath of Hurricane Katrina, many companies were adversely affected by the resulting price spikes in energy products, such as oil and natural gas.

The insurance industry was particularly hit hard.  Many insurance firms were searching for a mechanism to hedge against catastrophic weather, something that only a futures exchange could effectively provide.

Analysts like the idea of trading a new product, but are not convinced that big hurricanes will be a big business. “It’s a nice move but not a needle mover,” said Scott Appleby, a research analyst at Deutsche Bank AG.  “This doesn’t change our rating for the company.”

Appleby rates the stock as a buy with a $605 target price.

Morningstar Inc. analyst Patrick O’Shaughnessy agreed, but added that “in the long run, the insurance industry might become a major market for the CME.”  He also rates the company as a buy with a target price of $627.

In early trading, CME stock rose to $575.06, up $3.06 the previous day.

CME began trading weather derivatives in 1999.  CME’s weather contracts traded in 2006 had an approximatevalue of $22 billion, according to the exchange,.  The contracts are based on aggregate temperatures on 35 cities around the world and on snowfall and frost indexes.

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