ON WEATHER SENSITIVITY IN RETAIL INDUSTRY: WEATHER RISK MANAGEMENT

WEATHER RISK MANAGEMENT

Retailers often blame the weather for poor sales, but the review of literature found a handful of studies that analyze the impact of weather in retail. Such discrepancy can be explained by the fact that many retailers are nonspecialized and offer diverse assortment of products which results with diversified and thus mitigated effects of weather on retail sales. Myers (2008) states that product line diversification is one of the basic tools for weather risk management in practice. Advantages of product line diversification are that it is easy to implement and that it is inherent in operations of many retailers. At the same time, product line diversification possesses many disadvantages compared to the other weather risk mitigating tools. The main disadvantage of product line diversification is risk retention within the company as opposed to the risk transfer tools that allow for risk transfer to other parties able to manage it more effectively.

Recent literature proposes weather derivatives as sophisticated protection against non-catastrophic weather risk (Brockett et al., 2005). Weather derivatives are financial contracts traded on derivatives markets, designed to provide indemnity in the case of adverse weather and as such serve as hedge against weather risk. The underlying asset of weather derivatives is weather index and, since weather is not a physical good, there is no spot market for weather indices. However, even though weather cannot be physically traded, weather derivatives market allows for exchange of financial exposure to weather (Lazibat and Stulec, 2011). The purpose of weather derivatives application is to smooth revenues, cover excess costs, reimburse lost opportunity costs, stimulate sales and diversify investment portfolios (Leggio, 2007). Weather derivatives are primarily hedge against non-catastrophic weather risk, i.e. small deviations from usual weather such as colder than usual summer or warmer than usual winter. Beside temperature deviations, weather derivatives can provide hedge against deviations from usual rainfall and snowfall, wind speed, number of sunshine hours, days in which frost or fog were recorded, etc.

Several cases of weather derivatives application in retail have been recorded in practice. Manufacturer and retailer of winter apparel Weatherproof Garment Company bought the protection against warm winters in the form of weather derivative (Morrison, 2009). Canadian snowmobile manufacturer and retailer Bombardier used weather derivatives to cover the costs of promotional campaign. It promised its customers a discount of $1,000 if the snowfall in certain parts of the country does not reach a predetermined level (Myers, 2008). Bombardier’s goal was to protect customers from the risk of a mild winter and a perception of wasted money. To cover the cost of price reductions, Bombardier bought the weather derivative with snowfall as underlying weather index. Similarly, tire manufacturer Michelin guaranteed its buyers of winter tires a refund in the amount of $50 if the average winter temperature would not fall beneath 7°C. A refund was financed from indemnity paid by the weather derivative (Huault and Rainelle, 2011).