02 February 2012

How Wall Street makes money from bad weather

Explained in Time's business section:
Financial contracts based on the weather have been around since at least the late 1990s. The contracts, many of which trade like stocks, are typically pegged to such things as rainfall and temperatures. But in the past few years, contracts specifically tied to snowfall have started to take off in popularity. The contacts essentially act like insurance, allowing, say, retailers or ski mountains to insure against too much snow or too little. Wall Street sells the contracts, matching buyers and sellers and pocketing a small commission. Typically, it’s a good business, but this year it could be a real moneymaker. In theory, there could be as many firms betting against snow as for it. But in reality the market is always lopsided. It turns out there are more firms that are hurt by large snowfalls than the opposite. And large ski mountains have yet to get into the market...

The result: unable to find sellers, brokers who specialize in the market say financial firms ended up taking other side of the trade in order to complete their clients transactions, essentially betting that snowfall would be light this year. “I’m short snow,” says Bill Windle, who heads up weather trading at reinsurance firm RenRe...

Just how much money the financial firms will rake in and who will profit is unclear. Last year, PriceWaterhouseCoopers estimated that the total weather derivatives market was $12 billion. Snow is only a small portion of that, perhaps a few hundred million. But it’s growing... 
Nothing wrong with that; perfectly legal, and it fills a market need.  But I'll bet when the demand is lopsided the cost of the contract is tilted much more heavily against the buyer.  More details at the Time article.

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