Editor's Note: Thist story was originally published in the May 1998 edition of Scientific American. We are posting it in light of recent news involving Lehman Brothers and Merrill Lynch.
Months before El Niño– driven storms battered the Pacific Coast of the U.S., the financial world was making its own preparations for aberrant weather. Beginning last year, an investor could buy or sell a contract whose value depended entirely on fluctuations in temperature or accumulations of rain, hail or snow.
These weather derivatives might pay out, for example, if the amount of rainfall at the Los Angeles airport ranged between 17 and 27 inches from October through April. They are a means for an insurer to help provide for future claims by policyholders or a farmer to protect against crop losses. Or the contracts might allow a heating oil supplier to cope with a cash shortfall from a warmer than expected winter by purchasing a heating degree-day floor—a contract that would compensate the company if the temperature failed to fall below 65 degrees as often as expected. “We’re big fans of El Niño because it’s brought us a lot of business,” comments Andrew Freeman, a managing director of Worldwide Weather Trading, a New York City–based firm that writes contracts on rain, snow and temperature.
Weather derivatives mark an example of the growing reach of a discipline called financial engineering. This bailiwick of high-speed computing and the intricate mathematical modeling of mathematicians, physicists and economists can help mitigate the vagaries of running a global business. It entails the custom packaging of securities to provide price insurance against a drop in either the yen or the thermometer. The uncertainties of a market crash or the next monsoon can be priced, divided into marketable chunks and sold to someone who is willing to bear that risk—in exchange for a fee or a future stream of payments. “The technology will effectively allow you to completely manage the risks of an entire organization,” says Robert A. Jarrow, a professor of finance at Cornell University.
The engineering of financial instruments has emerged in response to turbulence during recent decades in ever more interconnected world markets: a result of floating exchange rates, oil crises, interest- rate shocks and stock-market collapses.
The creative unleashing of new products continues with increasingly sophisticated forms of securities and derivatives—options, futures and other contracts derived from an underlying asset, financial index, interest or currency exchange rate. New derivatives will help electric utilities protect against price and capacity swings in newly deregulated markets. Credit derivatives let banks pass off to other parties the risk of default on a loan. Securities that would help a business cope with the year 2000 bug have even been contemplated. This ferment of activity takes place against a tainted background.
The billions of dollars in losses that have accumulated through debacles experienced by the likes of Procter & Gamble, Gibson Greetings and Barings Bank have given derivatives the public image of speculative risk enhancers, not new types of insurance. Concerns have also focused on the integrity of the mathematical modeling techniques that make derivatives trading possible.
Despite the tarnish, financial engineering received a valentine of sorts in October. The Nobel Prize for economics (known formally as the Bank of Sweden Prize in Economic Sciences) went to Myron S. Scholes and Robert C. Merton, two of the creators of the options-pricing model that has helped fuel the explosion of activity in the derivatives markets.