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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