Guarding against risk

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What is the connection between ice cream and hedging risk?

Julia Warrander and Russell Waite reply:

AS the sun has been shining, let’s talk about ice cream. It is estimated that by 2022 the value of the global ice cream market will be around $90bn. While New Zealand leads the world in ice cream consumption per capita, it is the residents of the United States which indulge the most in terms of volume. Of all US households, 98% purchase ice cream, with each person eating the equivalent of 25 litres, on average, every year. A total of 87% of Americans have a ‘store’ of ice cream in their freezer and 19% are fanatical enough to hide containers where family members won’t see them.

This love is not unconditional – it waxes and wanes with the weather. A few cool weeks in the middle of summer and ice cream sales plummet. Unseasonably cold weather can therefore wreak havoc with the profits of ice cream makers. In just the same way, a gas company’s earnings will suffer during a very mild winter. ‘We cannot control the weather’ could be the comment from their CEOs when announcing a drop in profits to shareholders. We say ‘could’, because either enterprise may have taken the opportunity to hedge against this weather risk.

A hedge is a way of protecting oneself against financial loss or other adverse circumstances. There are many things people cannot influence, but they can – nonetheless – protect themselves against. For example, homeowners are unable to control the course or severity of storms, but they can buy a simple insurance policy to protect their finances from the full cost of any repairs. In this instance, they hedge their weather risk. The equivalent of the home insurance policy, or hedge, available to our ice cream maker or the gas company comes in the form of a weather derivative. It delivers protection, as a cash payment, when adverse weather conditions dent the profits of either business.

In the investment world derivatives are used to protect the value of portfolios. They provide a hedge against different kinds of risk we cannot influence: equity markets falling, interest rates rising or bond issuers defaulting. The investor simply pays a premium to buy the hedge.

Derivatives are as variable in type as ice creams are in flavour – but are probably not as enjoyable in the sunshine.

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