Understanding corporate finance: derivative contracts: futures: example of a weather future
A weather future
Ellspat Ltd runs a chain of cafes in tourist locations in the south of England. Its summer business is heavily dependent on the weather - the cooler the summer weather, the lower its takings. The company decides to hedge the risk by investing in weather futures.
Since the company wishes to profit if average temperatures in the London area fall, the company needs to take a short position, in other words to sell futures contracts.
(Someone who owns a physical commodity - often expressed as being long the physical - risks financial loss if prices fall. They will therefore want to hedge their position by going short the future - selling futures contracts (without previously owning them). If prices fall, they can close out their position by buying futures at a lower price, thus realising a profit. The same terminology is used even where you are dealing with a subject matter, such as weather, which cannot be owned or delivered.)
On the first business day of June, Ellspat Ltd sells 10 monthly weather index futures. The value of each contract is £3,000 per 1 degree C change in the monthly average temperature, measured at Heathrow airport.
On the first day of June, when the company sells the futures, the average daily temperature is 19.50 degrees C. The futures are quoted at 119.50 (100 plus the temperature in degrees C).
By the 20 June, the mean of the average daily temperatures for the month is 21.30 degrees C. The futures are therefore quoted at 121.30. The weather has turned hot and sunny, and Ellspat Ltd decides to close out its position by buying 10 futures.
It has sold at 119.50 and bought at 121.30, and has therefore sustained a loss. Since each 1 degree C change in temperature is worth £3,000, its loss is
(121.30 - 119.50) x £3,000 x 10 contracts = £54,000.
The company will have been required to put up initial margin and will, in practice, have realised profits or losses on a daily basis, as in the previous example.