Weather Derivative Definition How It Works Types Examples
Weather Derivative: Definition, How It Works, Types & Examples
Ali Hussain has a background in finance with large financial institutions and journalism covering business.
What Is a Weather Derivative?
A weather derivative is a financial instrument used to hedge against weather-related losses. The seller agrees to bear the risk of disasters in return for a premium. If no damages occur before the contract’s expiration, the seller will make a profit. In the event of unexpected or adverse weather, the buyer claims the agreed amount.
Key Takeaways
– Weather derivatives hedge against weather-related losses.
– They trade over-the-counter (OTC), through brokers, and on exchanges.
– Weather derivatives work like insurance, paying out if weather events occur or losses are incurred due to weather-related events.
– Agriculture, tourism and travel, and energy are sectors that use weather derivatives to mitigate risks.
Understanding Weather Derivatives
The profitability and revenues of industries such as agriculture, energy, entertainment, construction, travel, and others depend on temperature, rainfall, and storms. Weather derivatives allow companies to hedge against adverse weather that might affect their business. Businesses like hydroelectric companies and event managers use weather derivatives as part of their risk-management strategy. Farmers can hedge against poor harvests caused by weather conditions. Nearly one-third of the world’s GDP is affected by climate.
Weather derivatives began trading in 1997 and are now available on exchanges. The Chicago Mercantile Exchange (CME) lists weather futures contracts for several cities, mainly in the U.S. Investors appreciate weather derivatives for their low correlation with traditional markets.
Types of Weather Derivatives
Weather derivatives are based on indexes that measure specific aspects of weather. For example, an index can measure total rainfall or the number of days the temperature falls below freezing.
An index known as heating degree days (HDD) records the daily mean temperature falling below a reference point over a specified period. The final count determines whether the seller pays out or receives payment.
Weather Derivatives vs. Insurance
Weather derivatives and insurance cover different types of events. Insurance covers low-probability catastrophic events like hurricanes and earthquakes. Derivatives cover higher-probability events like dryer-than-expected summers. Weather derivatives protect against demand reduction caused by slightly different weather conditions, whereas insurance requires demonstrated losses.
Weather Derivatives vs. Commodity Derivatives
Utilities or commodity derivatives hedge prices based on specific volumes, while weather derivatives hedge the risk for yield and utilization. A combination of weather and commodity derivatives is best for overall risk mitigation.
What Are Climate Derivatives?
Climate derivatives hedge against financial losses related to adverse weather conditions. The buyer receives a monetary payment from the seller if certain climate events occur or if the buyer suffers financial losses due to a climate event.
How Do Weather Derivatives Work?
Weather derivatives involve a contract between a buyer and seller. The seller receives a premium and agrees to provide monetary compensation if the buyer suffers economic losses or adverse weather occurs. If no adverse weather events occur, the seller makes a profit through the premium.
What Are the Types of Derivatives?
Options, futures, forwards, and swaps are the main types of derivatives. They are financial instruments tied to an underlying asset.
