Question

Heating degree-day (HDD) and cooling degree-day (CDD) futures contracts make payments based on whether the temperature is abnormally hot or cold

. Required: a) Illustrate how these types of contracts are traded on the Chicago Mercantile Exchange (CME) using example(s)

. b) Evaluate why the following business might be interested in such a contract

:i) Soft drink manufacturers;

ii) Ski resort operators;

iii)Electric utilities;

iv)Amusement park operators.

Answer 1

A) HDD & CDD represent energy industry standard measures of the extent to which average temperatures during a particular day deviate from a (benchmark) of 65 degrees Fahrenheit. Value of these contracts are determined as below:

HDD = Max (0, 65 degree F - average daily temperature)

CDD = Max (0, Average daily temperature - 65 degree F)

The original HDD and CDD futures are based on the cumulative value of HDDs or CDDs throughout a specific subject month. To illustrate, an average daily temperature of 45°F degrees is associated with an HDD of 20 (= 65°F - 45°F). If the average daily temperature were in excess of 65°F, the HDD for that day would be zero. A monthly contract is cash settled at the cumulative value of HDDs recorded on each day of the month.

For example, assume that the month had 31 days and the average daily temperature for all of those days was 45°F. Accordingly, the cumulative monthly HDD would equal 620 (= 31 days x 20). The futures contract value would be identified by multiplying that figure by $20. In this example, the cash value of the contract would be $12,400 (= $20 x 620).

B.

1. Soft drink manufacturers sales depends upon the levels of heat, if whether turns more to heat then these manufacturers enjoy good sales while on the other hands cold weather may have negative impavct on demand of soft drinks. To hedge cold environment risk they can buy HDD.

2. Ski resort operators depend upon cold climate for their business. therefore to hedge out risk of heat they can buy CDD.

3. Electric Utilities depends on more cold or heat temperatures because both of them will result in excess demand of electricity due to heaters and air conditioning respectively. Therefore these service providers can buy CDD and HDD to hedge out both risks.

4. Amusement park operators gets huge demands in the time of high hot weather, therefore they can buy HDD to hedge out risk of cold environment.

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