Weather Futures: What They Are and How They Work

Key takeaways

• Weather futures are financial contracts that pay based on the value of a weather index (most often temperature-based).
• Payments typically depend on cumulative Heating Degree Days (HDD) or Cooling Degree Days (CDD) over a specified period.
• They let businesses hedge revenue or cost exposure tied to weather—common users include energy, agriculture, travel, and construction.
• Standardized, exchange‑traded weather futures were introduced by the CME in 1999; most are cash‑settled using published temperature indexes.

What is a weather future?

A weather future is a derivative whose payoff is tied to a measurable weather index (usually temperature) over a defined time frame—commonly a month or season. Instead of delivering a physical commodity, these contracts settle in cash based on the final value of the underlying weather index.

HDD and CDD — the core metrics

Temperature-based weather futures most often use:
* Heating Degree Days (HDD): For each day, HDD = max(0, 65°F − average daily temperature). HDD accumulates across the contract period; higher HDDs indicate colder conditions and more heating demand.
* Cooling Degree Days (CDD): For each day, CDD = max(0, average daily temperature − 65°F). Higher CDDs indicate hotter conditions and more cooling demand.

65°F (18°C) is used as a benchmark where minimal heating or cooling is assumed.

Example: If a month’s HDD index equals 100 and the contract multiplier is $20 per HDD, the contract’s settlement value would be 100 × $20 = $2,000.

How payouts and hedges work

• Payoffs are based on the indexed cumulative HDD or CDD for the contract period multiplied by a contract-specified dollar factor (the multiplier can vary by contract).
• A party exposed to weather-driven revenue risk can use weather futures to offset that risk. For example, a heating supplier that loses revenue when winters are warmer than expected can take a position in an HDD-linked contract that produces a payoff when HDDs are low or structure a position that offsets that loss.
• Contracts are typically cash-settled—no physical delivery—so settlement depends only on the published index value.

Market history and standardization

• Weather derivatives began as bespoke, over‑the‑counter instruments in the early 1990s.
• In 1999 the Chicago Mercantile Exchange (CME) introduced standardized, exchange‑traded weather futures and options. These contracts trade electronically with transparent prices.
• CME weather contracts use published indexes (monthly/seasonal averages) for select U.S. and European locations. Final settlement values for many exchange-traded contracts are calculated by an independent data provider.

Who uses weather futures?

Industries with weather-sensitive revenues or costs commonly use these products:
* Energy producers and utilities (heating and cooling demand)
* Agriculture and agribusiness (temperature impacts on crop yields)
* Travel, tourism, and outdoor entertainment (attendance and operations)
* Construction and transportation (weather-related delays and demand)

A sizable portion of economic activity is weather-sensitive; weather derivatives provide a tool to transfer that risk between market participants.

Benefits and limitations

Benefits:
* Targeted hedge against measurable weather risk without insuring physical damage.
* Standardized, liquid (for exchange-traded contracts) risk-transfer mechanism.
* Cash settlement avoids delivery logistics and uncertainty.

Limitations and risks:
* Basis risk: the index used may not perfectly match a firm’s actual exposure (e.g., city-level temperature vs. microclimate).
* Data risk: payouts rely on the accuracy and methodology of the index provider.
* Market liquidity: not all locations or contract structures have deep liquidity.
* Complexity: structuring an effective hedge often requires meteorological and financial expertise.

Accessing weather futures

• Exchange‑traded contracts are available on venues such as the CME for listed locations and periods.
• Over‑the‑counter (OTC) weather derivatives are still used for bespoke hedges when standard contracts don’t match a party’s exposure.
• Institutional or professional advice is recommended to design, price, and execute appropriate positions.

Conclusion

Weather futures convert measurable weather outcomes into tradable cash flows, giving businesses a way to hedge revenue and cost volatility driven by temperature and other weather variables. They are most effective when the chosen index closely matches the user’s underlying exposure and when parties understand the inherent basis and data risks.