Definition of weather derivative

Weather derivatives are financial instruments that can be used for risk management purposes to hedge against losses due to adverse, unpredictable weather. In contrast to other derivative products, the underlying asset - such as frost, rain, temperature and wind - has no direct value with respect to the price of the weather derivative.

The party that sells a weather derivative bears this risk for a premium and stands to earn a profit if the weather remains relatively stable, predictable or normal. If the weather does turn bad, then the party that purchases the derivative claims the agreed upon amount. As one would expect, temperature is the most commonly used underlying weather factor, 18 degrees Celsius (65 degrees Fahrenheit) is a standard baseline from which deviations are measured, but any other measurable weather-related event can be used as an underlying factor for a weather derivative.

As the underlying asset of the weather derivative is non-tradeable these instruments cannot be priced in the same way as more traditional derivatives. There is no standard model for valuing weather derivatives similar to the widely used Black-Scholes formula that is used to price many equity options and similar derivatives. As such they are more prone to modelling risk than other types of derivative products.

Example

The main users of weather derivatives are energy companies as demand for their products can vary drastically due to extreme weather conditions. The agricultural industry is the second main user of such instruments although other purchasers include firms arranging major sporting (outdoor) events and even tour operators. Hedge funds are reputedly also major investors in this alternative asset class.

A broad range of weather derivative products are available including options, futures, forwards and swaps. Most are traded over-the-counter (OTC) although there are some traded electronically on indexes like the Chicago Merchantile Exchange (CME). The CME offers weather derivative products that “offers trading opportunities related to temperatures, snowfall, frost and hurricanes. The products are based on a range of weather conditions in more than 47 cities in the United States, Europe, Canada, Australia and Asia, with the hurricane products geared to nine US regions.” (CME Group 2011) [1]

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