PRMIA Exam 8006 Topic 4 Question 91 Discussion

This question is based upon a weather derivative contract traded on the CME in the US. For each day, 'Heating-Degree-Days' (HDD) is calculated as equal to 65 degrees Fahrenheit minus the daily average temperature. The daily average temperature is based upon the temperature reported by the Earth Satellite Corporation using a specified automated weather station. Based upon daily values of HDD, an aggregated number called the 'CME degree days index' is calculated for each contract month. In other words, the index for a particular month is just the aggregation of the 'HDD' value for each of the days of that month. Each contract settles at the end of the month at a value equal to $20 x Degree Days Index. (In a similar way, 'Cooling Degree Days' are also calculated and a futures contract offered, except that CDD is equal to the average daily temperature minus 65 degrees). (Source: CME's website at CMEGroup.com)

In the given question, we are interested in hedging against the possibility of the temperature being too low. This means we should buy the HDD futures contract (the lower the temperature, the higher the difference of the average temperature from 65 degrees, and the higher the settlement). Therefore Choice 'b' is the correct answer. The lower the actual temperature turns out to be, the higher the payout to the grower. It would not be wise to wait till January to buy the contract as by then the prices of the contract would have already risen if the grower's fears of a colder January appear to be coming true. He can hedge his exposure by immediately locking in the January prices.