Weather Derivative

Weather Derivative

Key takeaways

• Weather derivatives are financial contracts that pay out based on an objective weather index (temperature, rainfall, snowfall, etc.) to hedge weather-related revenue or cost risk.
• They are used by agriculture, energy, tourism, construction, and event businesses to smooth earnings exposed to weather variability.
• Traded both over-the-counter (OTC) and on exchanges (e.g., CME), they offer low correlation with traditional financial markets but carry basis, model, and counterparty risks.
• Weather derivatives differ from insurance: they cover more frequent, non-catastrophic deviations (index-based payouts) and do not require proof of physical loss.

What is a weather derivative?

A weather derivative is a financial instrument whose payoff is tied to a weather-related index rather than a conventional asset price. Buyers pay a premium to a seller in exchange for a monetary payout if the agreed weather index crosses a predetermined trigger during the contract period. Because payouts depend on objective measurements, claimants do not need to demonstrate actual physical damage or revenue loss.

Common weather indices and contract types

Weather derivatives are typically indexed to measurable quantities, such as:
* Heating Degree Days (HDD) — cumulative degrees by which average daily temperature falls below a reference (commonly 65°F) over a period. Used to hedge winter heating demand.
* Cooling Degree Days (CDD) — cumulative degrees above a reference temperature; used to hedge summer cooling demand and energy use.
* Rainfall or snowfall totals — used by agriculture, recreation, and event businesses.
* Number of freeze days, wind speed exceedances, or other location-specific measures.

Contracts take forms similar to standard derivatives:
* Futures and options on weather indices (exchange-traded, standardized).
* OTC forwards, swaps, or options (customized terms).

Example (HDD): If reference = 65°F and a day’s mean temp = 50°F, HDD for that day = 15. A monthly HDD contract sums daily values; payout depends on whether the total exceeds a strike level.

How they work

1. Buyer and seller agree on index, location, period, strike (or range), and payout formula.
2. Buyer pays a premium (for options) or enters a swap/future position.
3. At contract settlement, the index is computed from reliable weather station or metered data.
4. If the index meets contract conditions, a predetermined cash payout is made to the buyer; otherwise the seller retains the premium.

Uses and industries

• Energy companies hedge demand/supply volatility tied to temperature.
• Farmers and agribusiness mitigate yield or revenue swings from drought or excess rain.
• Travel, tourism, and outdoor event organizers protect against weather-driven declines in attendance.
• Municipalities and infrastructure operators manage costs tied to extreme weather conditions.

OTC vs. exchange trading

• OTC contracts: customizable to location, period, and payout, but carry counterparty and liquidity risk.
• Exchange-traded contracts (e.g., CME weather futures): standardized, transparent pricing, and reduced counterparty risk via clearing, but less flexible.

Weather derivatives vs. insurance

• Insurance covers low-probability, catastrophic losses and generally requires proof of damage.
• Weather derivatives cover frequent, measurable deviations in weather that affect revenues/costs (e.g., a milder winter reducing heating demand) and pay based on index outcomes, not demonstrated loss.
• Many firms use both: insurance for catastrophic protection and derivatives for revenue smoothing.

Weather derivatives vs. commodity derivatives

• Commodity derivatives hedge price risk for a specified volume (e.g., barrels, bushels).
• Weather derivatives hedge utilization or yield risk linked to weather, independent of a fixed quantity—complements commodity hedges when volume/exposure is weather-dependent.

Benefits and risks

Benefits:
* Direct hedge of weather-driven revenue or costs.
* Objective settlement based on measured data.
* Low correlation with equity and bond markets—useful for portfolio diversification.

Risks:
* Basis risk — the index may not perfectly match the buyer’s actual exposure (location or measurement differences).
* Model risk — pricing requires weather and statistical models; errors affect valuation.
* Counterparty risk for OTC contracts.
* Liquidity constraints for customized or less common indices.

Brief history and market structure

Weather derivatives originated in OTC markets in the 1990s and moved to exchange trading within a few years. Major exchanges list standardized weather futures and options for select locales, while OTC markets provide tailored solutions for specific exposures.

Conclusion

Weather derivatives are specialized financial tools that allow businesses and investors to transfer measurable weather risk. When chosen and structured appropriately, they can effectively complement insurance and commodity hedging to reduce weather-driven volatility in revenues and costs. Careful attention to index selection, contract terms, pricing models, and counterparty/clearing arrangements is essential to manage the inherent risks.