Weather Derivative

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21 Aug, 2024

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Weather derivatives are financial instruments utilized by individuals or organizations to minimize the risk associated with weather-related losses. These securities are particularly useful for agricultural commodity firms that have acute exposure to weather. That said, applying these contracts is possible across several regions and industries.

Sellers of such assets accept the risk of any disaster taking place in exchange for a premium. Note that if any damage does not occur before the contract expires, the sellers generate a profit, whereas if adverse or unforeseen weather conditions transpire, the derivative’s buyer gets to claim the agreed amount.

What Is Weather Derivative?

Weather derivatives are risk management tools that enable companies and people to reduce the impact of unfavorable weather conditions on their business.
A key advantage of this derivative is that it can help companies in the energy sector reduce revenue volatility.
One drawback is that they do not have a definite pricing model. Another noteworthy one is that the payoff determination depends on the weather index value and does not consider the effect of unfavorable weather conditions.
A key difference between weather derivatives and insurance is that the former costs less.

Weather Derivative Explained

Weather derivative refers to financial instruments that organizations and individuals can utilize to hedge against losses resulting from adverse weather conditions. The application of such derivatives is possible across various industries and regions. This financial instrument is particularly useful for any agricultural commodity acutely exposed to weather.

The revenues and profitability of all industries, including energy, agriculture, travel, and construction, largely depend on the peculiarities of storms, rainfall, and temperature. Unforeseen weather conditions seldom lead to price adjustments that fully make up for the lost income. Such derivatives enable organizations to hedge against the risk of incurring losses arising from unfavorable weather conditions.

The organizations whose business relies on weather, for example, companies managing sporting events or hydroelectric businesses, might utilize these contracts as part of their risk management strategy. Meanwhile, farmers often use such financial instruments to minimize the risk of a poor harvest due to insufficient rain, destructive winds, or sudden temperature.

In 1997, such derivatives started being bought and sold over-the-counter(OTC), and in a few years, the financial instrument became tradable on exchanges. Moreover, some hedge funds started treating them as a class of investment. The Chicago, Illinois-headquartered Chicago Mercantile Exchange or CME, lists such derivatives for several cities, most of which are in the U.S.

Contrary to OTC contracts, CME weather futures are standardized derivative contracts bought and sold publicly on an open market in an environment that is similar to that of an electronic auction. Such an environment involves complete price transparency and continuous price transparency.

Types

Weather derivatives are index-based instruments. Such an index gauges a specific aspect of the weather. For instance, the index could be the amount of rainfall over a certain duration in a particular place. Another one can be for how many times the temperature drops below freezing.

One of the climate indices for such derivatives is Heating Degree Days (HDD). One can compute the HDD index by deducting the average of daily low and high temperatures from 65 Fahrenheit or 18 degrees Celsius., representing the point at which people generally switch on space heating. Note that negative values are not taken into consideration, and the daily HDD values are accumulated over seasonal or monthly periods.

Another climate index for this kind of derivative is Cooling Degree Days (CDD). The computation of CDD involves deducting 65 Fahrenheit or 18 degrees Celsius from the average of daily low and high temperatures. Similar to the index HDD, negative values are not taken under consideration, and the accumulation of the daily CDD values occurs over seasonal periods or monthly.

Examples

Let us look at a few weather derivative examples to understand the concept better.

Example #1

Suppose Sam is the seller of a weather derivative while Jack is the buyer. Sam receives a premium from Jack with the understanding that the former will give an amount if the latter incurs substantial economic loss owing to adverse weather conditions. No unfavorable weather event transpired. As a result, Sam made a profit via the premium received.

Example #2

In Q1 2023, Star Group, an energy company in the United States, benefited from weather derivative arrangements. It recorded a complete recovery under the terms of its DDC contract. The company has been utilizing such derivatives to mitigate financial risk for more than a decade, taking advantage of such arrangements when the weather conditions in areas where they operate in the United States were at the levels that set off parametric derivative contracts.

Weather causes customer usage to fluctuate, which impacts revenue. Hence, the company utilizes the degree day hedge for mitigating the weather risk exposure, besides smoothing the revenues when the temperatures are higher than usual.

Advantages And Disadvantages

Let us look at the benefits and limitations of weather derivatives in finance.

Advantages

These financial instruments are less costlier than insurance policies.
The derivatives do not need any demonstration of loss.
These derivatives offer protection from losses resulting from unforeseen or unfavorable weather conditions.
Organizations can utilize these derivatives to cover excess costs, diversify investment portfolios, reimburse lost opportunities, stimulate losses, and smooth revenues.
These derivatives have effectively minimized revenue volatility in dairy production, tourism, and the energy sector.

Disadvantages

In the case of such derivatives, the determination of the payoffs occurs only based on the weather index value, irrespective of the actual impact of the adverse weather conditions.
Another major drawback of these derivatives is the effect of Geographical Basis Risk (GBR), which refers to the deviation of the weather conditions in different locations.
These derivatives do not have any definite pricing model as the underlying, for example, sunshine or rainfall, has no monetary value.

Weather Derivatives vs Commodity Derivatives

Let us look at some key differences between weather and commodity derivatives.

Commodity derivatives allow for price hedging on the basis of a particular volume. On the other hand, derivatives with sunshine or rainfall as underlying enable one to hedge the yield or the actual utilization, irrespective of the volume.
In commodity derivatives, the underlying asset has monetary value. On the other hand, a weather derivative’s underlying does not have monetary value.

Weather Derivatives vs Insurance

The differences between weather derivatives and insurance in finance are as follows:

Insurance offers financial protection from devastating or low-probability weather events, for example, earthquakes, tornadoes, and hurricanes. On the other hand, these derivatives minimize the risk arising from higher probability events like a dryer-than-anticipated summer.
Insurance policies do not provide coverage against a drop in demand because of a wetter summer than usual. That said, such derivatives can safeguard one from this type of risk.
Because the derivatives are index-based, a buyer does not have to show a loss. In contrast, individuals must show damages to get insurance.

Frequently Asked Questions (FAQs)

1. How are weather derivatives priced?

Different pricing methods have been utilized for these derivatives. A few of those methods are historical burn analysis, index modeling, and the actuarial method. That said, currently, daily average temperature or DAT modeling is the least demanding technique from a computational standpoint. Moreover, experts find it more accurate compared to the other methods.

2. What are the origins of weather derivatives?

The trading of these derivatives started in 1996 when Aquila Energy structured a dual-commodity hedge. This hedge was for a New York-based energy company called Consolidated Edison. After a year, the OTC trading of such derivates began.

3. Who are the users of weather derivatives?

The primary users of such derivatives are utility companies, as their business heavily relies on weather as well as its predictability. That said, other types of organizations (hedge funds, insurance companies, etc.), governments, and individuals, for example, farmers use such derivatives to mitigate financial risk.