The original idea of using futures contracts was in helping farmers to be insured from unfavourable fluctuations of prices on primary products. As of now, the industry significantly expanded and includes a lot more players.
Futures contracts allow their holders to buy or sell a physical asset or trading instrument on a specified date at a specified price. A special place in this variety of financial derivatives is taken by the so-called exotic futures. Their price formation takes place on the basis of more complex conditions, such as, for example, political events or amount of precipitation in a certain city.
Nevertheless, these unusual futures serve a real economic purpose (which differs them from gambling) and allow people and enterprises to hedge risks. These trading instruments, as well as regular derivatives, are regulated through clearing chambers which guarantee execution of obligations of all parties of a trade.
In this article we present information about the most exotic futures. One of them is prohibited by the Dodd-Frank Wall Street Reform and Consumer Protection Act but the others are still traded on the exchanges.
In this article:
- Snowfall and rainfall futures
- Hurricane futures
- Movie futures
- Temperature futures
- Freight futures
- Employment futures
Thickness of precipitation on a certain territory can be traded as a futures contract or option. Futures contracts on precipitation on different continents and in many cities are traded on the Chicago Mercantile Exchange (CME).
Snowfall and rainfall futures can be used by utility companies, freight services, postal operators and farmers to hedge the risks connected with heavy precipitation. They also could be used by companies that provide services on treatment of roads with chemical agents to insure themselves from the risk of the low level of snow.
Hurricane futures are traded on the Chicago Mercantile Exchange (CME). They are based on the CME Hurricane Index, which reflects the size of a potential hurricane damage on the basis of the public domain data of the US National Weather Service.
There are futures contracts based on the CME Hurricane Index (CHI) for each hurricane with a name and also contracts based on specific geographical regions that suffered from these natural disasters.
Hurricane futures could be used by business owners, insurance companies, utility service suppliers and individual house owners.
The Commodity Futures Trading Commission (CFTC) received a proposal in 2010 to launch trading of futures contracts based on income from distribution of a movie during a set period of time (week or month). The Cantor (a part of Cantor Fitzgerald) and Trend exchanges were considered as trading platforms for this exotic trading instrument. Supporters of the so-called box office futures announced that these derivatives could be applied by motion picture studios, DVD distribution companies and cinema halls in order to hedge risks connected with a possible box office failure.
Unfortunately some Hollywood studios had a cautious attitude towards the idea to launch movie futures since they were afraid of insider trading and efforts of competitive studios to influence the public opinion though market manipulations. The US Congress had to prohibit box office futures under the pressure of movie giants and include them into the Dodd-Frank Act.
There are also futures based on average temperatures in certain geographical regions. These regions are identified by CME. The temperature is indexed and averaged, which produces monthly and seasonal values.
The companies that produce heating systems, manufacturers of air-conditioners and utility companies can use temperature futures to hedge their risks connected with an unusually warm winter or cold summer.
Until recently, insurance was the main instrument used by companies for protection of their businesses from unpredictable weather conditions. However, insurance provides protection only from the damage in the result of natural disasters. Insurance offers nothing for protection of the reduction of demand on business services in the result of too high or low temperature during certain seasons.
“Unlike various forecasts made by the government and independent meteorological centers, trading with weather derivatives gives market participants a quality view on these prospects” – said Agbeli Ameko, a managing partner of the EnerCast energy firm, in one of his interviews.
The first over-the-counter trade with weather derivatives was executed in 1997 when a whole sphere of weather risk management was also formed.
Futures contracts based on the cost of freight services were developed in order for the freight companies to have a possibility to hedge risks connected with increase of prices for transportation of commodities. These contracts are also called forward freight agreements (FFA). This instrument is traded on the Baltic Exchange in London.
CME also offers a possibility to trade derivatives based on one of the most sensitive parts of the US economy – employment sphere. A monthly report about a number of new non-farm payrolls in the US is one of the most important macroeconomic indicators that track changes in the employment market. The price of a derivative based on this indicator increases by USD 25 in the event of appearance of 1,000 new working places during the previous month.
The non-farm report is published by the US Bureau of Labor Statistics during the first week of each month. This report is one of the most important reports for the Wall Street. You can hedge risks or speculate on changes of this important statistical indicator with the help of CME derivatives based on the non-farm report.
It has to be noted that all the markets we mentioned in this article are peripheral. Many of them are inefficient and sometimes too volatile. You should have special knowledge and/or specific investor authorities in order to trade in some of them. These markets are rather big. Their annual turnover amounts to dozens of billions of dollars and all of them demonstrate a significant growth.
None of the futures contracts considered in this article can serve as the main instrument for trading or investing. This article is just a reminder that financial markets constantly grow and some innovations appear every year. The past experience shows that, in the end, all these innovations help to strengthen and improve the economy.