Weather derivative


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Weather Derivative

A derivative security in which an investor hedges against the future state of the weather. For example, two investors may enter a weather derivative, where one investor pays the other if rainfall in a given place over a given period of time is above a certain amount. Likewise, the other investor pays if the rainfall is below the agreed-upon amount. One of the most common weather derivatives is a weather future, in which the buyer is required to pay the seller $20 for each day in a given month that the daily temperature is below 65 degrees (a heating degree day) or above 65 degrees (a cooling degree day), depending on the nature of the contract. A weather future allows a business to hedge against potential losses resulting from an unexpected change in weather. Energy companies are some of the most common sellers of weather derivatives.

Weather derivative.

A weather derivative is a futures contract -- or options on that futures contract -- where the underlying commodity is a weather index.

These derivatives work much the same way that interest-rate or stock index futures and options do, by creating a tradable commodity out of something that is relatively intangible.

Analysts look at historical weather patterns -- temperature, rainfall and other things -- develop averages, and quantify the risk that weather will deviate from the average.

Corporations use weather derivatives to hedge their risk that bad weather will cause a financial loss. For a cereal company, bad weather might be a drought, which would cause wheat prices to go up. For a home heating company, it could be warm days in November, which could lower demand for home heating oil. And for an amusement park it could be rain.

The cereal company and the amusement park might buy futures contracts with an underlying weather index based on rainfall. The home heating company might want contracts based on a temperature index.

Weather derivatives are different from insurance, because they're linked to common weather events, like dry seasons, or a warm autumn, that affect particular businesses.

Insurance is still required to protect against major weather events, like tornadoes, hurricanes, and floods.

You can buy weather derivatives as an individual, but you'll want to consider the trading costs carefully to ensure that your risk of loss is worth the expense.

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References in periodicals archive ?
At the time of writing this review, a sampling of recent financial risk management news includes the following items: Japan's first weather derivative involving high wave levels recently went on sale; a development bank is readying what would be only the second weather-related bond offering for placement in the capital markets; and there are new efforts in the areas of providing real-time weather information and of weather derivative portfolio management software.
Weather derivative contracts may be written and based on the temperature at a station with 25 years of historical data.
Lynda Clemmons, the chief operating officer of Element Re Capital Products in Stamford, Connecticut, says that one client, a regulated utility, had invested in a single-year weather derivative and wanted to purchase a multiyear derivative.
This text points out that a disadvantage of weather insurance is that one has to show an insurable interest while, "An entity executing a weather derivative does not need to show an insurable interest in property, it just needs to be adversely impacted by fluctuations in weather." The text reports that in the year 2000, the General Counsel for the New York Insurance Department indicated that weather derivatives were not insurance.
Businesses, such as those in energy, agriculture and construction, can purchase a weather derivative. This is an instrument whose value depends on the quality of some underlying variable, in this ease, a weather index such as heating degree days, cooling degree days, average temperature or inches of precipitation.
The basic structure of a weather derivative is fairly simple.
The audience heard of the market failure that exists in the crop insurance and weather derivative market, that there is a need to continually improve Farm Management Deposits to ensure greater uptake and utilisation, and that there is a requirement to ensure that government risk management programs focus on preparation rather than reaction.
Brix, Weather Derivative Valuation: The Meteorological, Statistical, Financial and Mathematical Foundations, Cambridge University Press, Cambridge, UK, 2005.
As an institutional response to weather changes, the Chicago Mercantile Exchange (CME) introduced the weather derivative (WD).
Liu, "Modeling and forecasting average temperature for weather derivative pricing," Advances in Meteorology, vol.
In the United States, these risks are now primarily managed using weather derivative products since they became available on the CME in 1997.