Weather Derivative

A weather derivative is a financial instrument used by companies or individuals to hedge against the risk of weather-related losses. The seller of a weather derivative agrees to bear the risk of disasters in return for a premium. If no damages occur before the expiration of the contract, the seller will make a profit—and in the event of unexpected or adverse weather, the buyer of the derivative claims the agreed amount.

The profitability and revenues of virtually every industry—agriculture, energy, entertainment, construction, travel, and others—depend to a great extent on the vagaries of temperature, rainfall, and storms. Unexpected weather rarely results in price adjustments that entirely make up for lost revenue, making weather derivatives securities that allow companies to hedge against the possibility of weather that might adversely affect their business a pivotal investment for many.

Companies whose business depends on the weather, such as hydroelectric businesses or those who manage sporting events, might use weather derivatives as part of a risk-management strategy. Farmers, meanwhile, may use weather derivatives to hedge against a poor harvest caused by too much or too little rain, sudden temperature swings, or destructive winds.

CME weather futures, unlike OTC contracts, are standardized contracts traded publicly on the open market in an electronic auction type of environment, with continuous negotiation of prices and complete price transparency. Investors who like weather derivatives appreciate their low correlation with traditional markets. Weather derivatives typically have a basis to an index that measures a particular aspect of weather. For example, an index might be the total rainfall over a specified period in a specific place. Another can be for the number of times the temperature falls below freezing. 

One climate index for weather derivatives is known as heating degree days or HDD. Under HDD contracts, each day the daily mean temperature falls below a predetermined reference point over a specified period, the amount of the departure is recorded and added to a cumulative count. The final figure determines whether the seller pays out or receives payment.

Weather derivatives are similar to but different from insurance. Insurance covers low-probability, catastrophic weather events such as hurricanes, earthquakes, and tornadoes. In contrast, derivatives cover higher-probability events such as a dryer-than-expected summer.

Insurance does not protect against the reduction of demand resulting from a slightly wetter summer than average, for example, whereas weather derivatives can do just that. Since weather derivatives and insurance cover two different possibilities, a company might have an interest in purchasing both.

Also, since the contract is index-based, buyers of weather derivatives do not need to demonstrate a loss. In order to collect insurance, on the other hand, the damage must be shown.

investopedia