Weather derivatives

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Weather derivatives are financial instruments that can be used by organizations or individuals as part of a weather risk management strategy to reduce risk associated with adverse or unexpected weather conditions. Farmers can use weather derivatives to hedge against poor harvests caused by drought or frost; theme parks may want to insure against rainy weekends during peak summer seasons; and gas and power companies may use heating degree days (HDD) or cooling degree days (CDD) contracts to smooth earnings.

Typical terms for an HDD contract could be: for the November to March period, for each day where the temperature falls below 65 degrees Fahrenheit, keep a cumulative count of the difference between 65 degrees and the average daily temperature. Depending upon whether the option is a put option or a call option, pay out a set amount per heating degree day that the actual count differs from the strike.

Investors who sell weather derivatives agree to take on the risk for a premium. Investors will profit from these transactions if weather conditions remain normal. If the weather changes unexpectedly, the company that bought the derivative collects an agreed-upon amount. To trade these products market participants will use weather forecasts to predict how the weather conditions will affect the current and future market. Weather market players are from a variety of industries and other participants include hedge funds, institutional firms, and brokers.

Trading Process

The weather derivatives market trades both over-the-counter (OTC), through brokers, and over an exchange, CME Group. However, there is a direct interplay between these two marketplaces. Weather trades are very often confirmed OTC, and then "given up" to the CME for clearing. In this case, counterparties strike a bi-lateral transaction using a broker then process the trade through the CME, using established credit facilities to speed execution.[1]. The major weather brokers are:

History

The weather market has grown tremendously over the last few years and participants trade Over-the-counter and exchange-listed products at CME. The first weather derivative deal was in July 1996 when Aquila Energy structured a dual-commodity hedge for Consolidated Edison Co (Con Ed). The transaction involved ConEd's purchase of electric power from Aquila for the month of August. The price of the power was agreed to, but a weather clause was embedded into the contract. This clause stipulated that Aquila would pay ConEd a rebate if August turned out to be cooler than expected. The measurement of this was referenced to Cooling Degree Days measured at New York City's Central Park weather station. If total CDDs were from 0 to 10% below the expected 320, the company received no discount to the power price, but if total CDDs were 11 to 20% below normal, Con Ed would receive a $16,000 discount. Other discounted levels were worked in for even greater departures from normal[2].

In 2008, volume skyrocketed with the launching of OTC Weather auctions [3]. Not only has temperature-based weather volume grown, but other weather products have also seen success. Business in the CME Group Hurricane Products - now in their second year of trading - has increased dramatically. Also, two new online exchanges - StormExchange and Weatherbill - have driven the weather derivatives market from mainly energy traders to a whole new set of end-users. Both firms have been successful in speaking to end-user traders that are affected by day-to-day weather conditions. These firms have been successful in educating and monatizing their weather risk and structuring over-the-counter weather deals that are customized to their needs.

Resources

References

  1. What are weather derivatives. Evolution Markets.
  2. Financial Impact of Weather on Business. MSI GuaranteedWeather.
  3. TFS Energy Launches Weather Auctions. TFS Energy.