Investigating supply chain contracts under weather-sensitive demand

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Changes in weather not only affect daily lives but also pose financial risks to businesses by influencing consumer demand for many products and affecting the quality of others. Retailers are encouraged to place orders for weather-sensitive products long before a season starts, but history has shown that unexpected weather patterns (an abnormally mild winter, for example) can result in significant drops in demand, leading to huge losses for companies and impacting overall economic activity. In June 2005, for example, Walmart reported that below-normal temperatures had caused a higher-than-normal inventory level in its weather-sensitive products. It is well understood in supply chain management that inventory of the wrong product in the wrong place at the wrong time costs money. The products of 70% of American companies are weather sensitive, and about half of its GDP is affected by weather. To minimize the risk from weather-sensitive demand, in 1999 the financial market introduced a financial instrument called the weather derivative. Weather derivatives allow a corporation to transfer its weather risk to another party willing to absorb it in the form of options, futures or swaps. The value of such derivatives is derived from an underlying variable in the case of weather, temperature, rainfall, or snowfall. The Chicago Mercantile Exchange (CME), which introduced weather derivatives, traded $32B in weather derivatives in 2007. Surprisingly, little research has been done on weather risk in supply chains. This research will be the first to investigate how one measurement of weather condition temperature affects the supply chain, how supply chains may be better coordinated considering weather-sensitive demand, and how supply chain contracts can be optimized by hedging weather risk using weather derivatives. It will develop theories and guidelines so retailers can implement supply chain management strategies, risk hedging, and contracts that minimize costs. Recently, retailers including Walmart, Rona and Home Depot, and energy companies including Duke Power and Progress Energy have moved towards taking weather information into account when predicting product demand to make supply chain decisions. Acknowledging the increasing importance and magnitude of weather risk in supply chain contracts, this research will not only play a critical role in helping astute retailers and producers minimize downside risk, but also enhance research knowledge in this area.