Heating and Cooling Degree Days (HDD and CDD respectively) represent industry standard measures of the extent to which average temperatures during a particular day deviate from a benchmark of 65 degrees Fahrenheit.

When temperatures fall below 65 degrees, each degree of mean temperature below 65 is counted as one heating degree day. Likewise, each degree of mean temperature above 65 is counted as one cooling degree day. These can be expressed as: HDD = Max( 0, 65F daily average temperature) CDD = Max( 0, daily average temperature 65F)

For example, if the average of a days maximum and minimum temperature on a midnight-to-midnight basis is 45F, that days HDD is 20 and the CDD is zero.

To create an index over period of time, the HDD and CDD are cumulated. So for instance, suppose that for the month of April the average daily temperature in New York was 53 degrees. The April HDD index would be 360 ( MAX[0,65-53] x 30 ). Options on HDD and CDDs trade on a monthly basis, and each index point in the money pays $20 per option contract. If you had a call option on the April HDD index with a strike of 350, you would earn 10 x $20 or $200.

You are a power supplier for parts of the city of NY. For the last five years, the average daily temperature in June for the city has been 73.7F. If the average daily temperature for June goes above 76 F your company losses $12,000 per degree per day.

1. What kind of contract would you use, an HDD or a CDD, to hedge this risk?

2. Suppose you buy options based on the 76F temperature, what monthly index strike does this correspond to?

3. How many options should you buy, if the settlement is $20 per index point? (Assume the worst case scenario, you predict every day above 76F)