Come wind, come weather
Many of the new alternative asset classes are emerging from entities that did little securitisation in the past. Insurance companies, for example, are increasingly looking to the capital markets for risk capital.
Comparing traditional reinsurance with an index-linked security is similar to comparing a forward contract with a futures contract. The traditional reinsurance coverage is very specific and client-tailored. The buyer’s main risk is reinsurer credit risk. Conversely, the main risk to a buyer of an index-linked product is basis risk (exposure deviation from underlying index).
An example of index-linked notes is ModILS (Modeled Index Linked Securities), which are floating-rate notes where the principal is guaranteed (subject to index performance) by the collateral account (similar to a clearing house). The performance of ModILS transactions depends on the underlying index, which could be comprised of factors such as:
q New Madrid earthquake
q California earthquake
q East Coast/Gulf hurricane
ModILS offer diversified exposure to catastrophic risk in the US. The notes pay coupons of US dollar Libor plus a spread. Coupons and principal will be paid in full if there are no qualifying events, meaning the index value does not exceed its threshold. Every event does not necessarily trigger an adverse development for the noteholder. As with most traditional covers, only exposure above a certain threshold affects the underlying index. Thus, the Libor rate plus a spread is the maximum return that can be realised if the security is held to maturity. The worst-case return is a 100% loss. In general, the probability of losing 100% is very low and the spread above Libor is set to compensate for that risk. In this sense, these instruments are similar to medium to low grade bonds.
Like insurers, utility companies are also looking to the capital markets for risk capital. The main risk to a utility company is often weather-related. For example, during an unusually warm winter, heaters may not be used. This affects electricity, oil and gas demand and subsequently, utility revenue. Weather derivatives can offset this exposure. As a result, derivatives trading desks are emerging at the major utilities throughout the world. Investment banks and reinsurers are also writing these instruments, though they are mainly facilitators rather than net buyers or sellers.
Weather derivatives are offered in the form of options on temperature. They have a strike temperature rather than a strike price and the underlying index is temperature rather than a financial index. The options are more Asian than European or American in the sense that it is the total daily temperature over the duration of the contract that decides whether or not a payoff is due, thus eliminating exposure to end-of-period aberrations. If the option provides a payoff for high temperatures (above the strike) then those days are referred to as “cooling degree days”. Conversely, if the option provides a payoff for low temperatures, then those days are referred to as “heating degree days”.
There is much theory to be developed on how to price all these new instruments. At this juncture, the market remains fairly illiquid and the instruments are not easily replicated. Thus, traditional risk-neutral pricing of cashflows is not readily applicable. However, if we know the risk of a given investment alternative, we can determine the return (and thus the price) at which the alternative asset class becomes a viable option. For a given company with a given risk and reward perspective, the price may consequently differ from the price its peers are willing to pay. This is referred to as marginal pricing and has some interesting implications that are beyond the scope of this article. Reconciling marginal with risk-neutral pricing will be an interesting area of financial engineering during the next few years.
As the theory and expertise expand, more alternative issues will follow. We are already beginning to see derivatives on river waterflow and movies to name a few. So far, the interest has been mainly on the side of the issuers. In other words, the market has been supply-driven as holders of risk try to pass on certain balance sheet risks. As we enter the new millennium, it will be interesting to see if asset managers (perhaps offering alternative investment funds) begin increasingly to demand alternative investments to capitalise on the diversification benefits. As we have briefly noted, there is a price at which it is worth the investment.