Weather Derivatives
Introduction
Weather derivatives are financial instruments that businesses use to hedge against the risk of weather-related losses. The buyer of a weather derivative pays a premium to the seller who, in return, agrees to compensate the buyer if a specific weather event occurs. The payout is determined by a formula in the derivative contract.
History
The concept of weather derivatives originated in the United States in the late 1990s. The Chicago Mercantile Exchange (CME) introduced the first exchange-traded weather futures contracts and options in 1999. These contracts were based on heating degree days (HDD) and cooling degree days (CDD), two common measures of energy demand related to weather.
Types of Weather Derivatives
There are several types of weather derivatives, including temperature-based derivatives, precipitation-based derivatives, and wind-based derivatives.
Temperature-Based Derivatives
Temperature-based derivatives are the most common type of weather derivative. They are typically based on heating degree days (HDD) or cooling degree days (CDD).
Heating degree days (HDD) are a measure of the demand for energy needed to heat a building. Cooling degree days (CDD) are a measure of the demand for energy needed to cool a building.
Precipitation-Based Derivatives
Precipitation-based derivatives are used to hedge against the risk of either too much or too little rain. These derivatives are often used by entities such as water utilities, agriculture businesses, and outdoor event organizers.
Wind-Based Derivatives
Wind-based derivatives are used to hedge against the risk of too much or too little wind. These derivatives are often used by wind farm operators.
Pricing and Valuation
The pricing and valuation of weather derivatives can be complex. It involves the use of historical weather data, the current and forecasted weather conditions, and the specific terms of the derivative contract.
Monte Carlo simulation is often used in the pricing and valuation of weather derivatives. This is a mathematical technique that generates random variables for modelling risk or uncertainty of a certain system.
Uses and Applications
Weather derivatives are used by a wide range of businesses to hedge against the risk of weather-related losses.
Energy companies, for example, use weather derivatives to hedge against the risk of a warm winter reducing demand for heating, or a cool summer reducing demand for air conditioning.
Agriculture businesses use weather derivatives to hedge against the risk of a drought or flood damaging crops.
Outdoor event organizers use weather derivatives to hedge against the risk of a rain-out.
Market and Regulation
The market for weather derivatives has grown significantly since the first contracts were introduced by the CME in 1999. Today, weather derivatives are traded both on exchanges and over-the-counter.
In the United States, weather derivatives are regulated by the Commodity Futures Trading Commission (CFTC).
Criticisms and Controversies
While weather derivatives provide a valuable tool for businesses to manage weather-related risk, they have also been subject to criticism and controversy.
Some critics argue that weather derivatives can contribute to price volatility in energy markets. Others have raised concerns about the potential for manipulation of weather data, which is used in the pricing and settlement of weather derivatives.