How do weather derivatives work?

Learn why weather derivatives are typically used by organisations

Weather derivatives are financial products that derive their values from weather-related variables such as temperature, rainfall, snowfall, frost and wind.  Weather derivatives are typically used by organisations to hedge or mitigate the risks associated with adverse or unexpected weather conditions.  Typical users of weather derivatives include farmers wishing to hedge against poor harvests caused by frosts or low rainfall, and energy companies who may use weather derivatives to smooth earnings caused by unseasonably warm or cool temperatures.

Commonly used weather derivatives include futures or options contracts linked to heating degree day (HDD) and cooling degree day (CDD) indices with final pay outs linked to the index.  HDDs are calculated as the number of days in a set period, multiplied by the difference in the average temperature (calculated as the midpoint of the day’s high and low temperatures) from 18 degrees Celsius, which has been determined as the ideal temperature where no heating or cooling is required.  For example, if the average temperature measured at the Sydney Airport weather station was 12 degrees Celsius on every day in June, then the HDD index for June would be 30 days multiplied by six degrees (i.e. 18 less 12) or 180.  CDDs are the reverse, measuring the number of days that cooling or air conditioning may be required when the average temperature exceeds 18 degrees Celsius.

Other weather derivatives are linked to snowfall, rainfall, hurricanes and frosts.  Hurricane indices include factors such as the number of named hurricanes, wind speed and hurricane radius.  Frost derivatives are linked to temperatures at which frosts occur.

The first weather derivative was developed in 1996 when two energy companies agreed to a power supply agreement which contained a clause that allowed for the electricity price to be adjusted based on the CDD index in a particular summer month.  If the weather was particularly hot, then electricity demand to power air-conditioners would rise, and the price of electricity supplied would fall – in effect a volume discount.  Since then futures and options exchanges such as the Chicago Mercantile Exchange have created weather-related futures and options contracts, which even include some denominated in Australian Dollars that are linked to HDDs and CDDs in Sydney, Brisbane and Melbourne.

Settlement of weather derivatives is always in cash, as opposed to many other derivatives where counterparties can physically deliver the underlying commodities or securities at the expiry of the contract. The cash settlement value is calculated based on the final value of the HDD, CDD, rainfall, snowfall or hurricane index multiplied by a certain price, for example $20 per index point.

In addition to energy companies and farmers using weather derivatives for risk management, some hedge funds have been investing in weather derivatives as a way of generating investment returns that are not correlated or linked to other asset classes such as shares and bonds.  Because the valuation of weather derivatives is not straightforward compared to derivatives linked to other commodity and securities prices, hedge funds can apply sophisticated valuation techniques to try to find opportunities in the weather derivatives market.  Techniques include building meteorological weather forecasting models, looking at prices that companies may be prepared to pay to “guarantee” weather conditions and looking at the prior performance of weather derivatives.

Because it is quite difficult to predict the weather, investing in weather derivatives can be a relatively risky proposition and hedge funds that invest in this area need to employ weather experts and strong risk management techniques to ensure that they do not lose significant amounts when they get their weather forecasts wrong.



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