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:: What are Weather Derivatives? ::

The weather has an enormous impact on businesses, for example, energy producing companies, travel agents and wine producers.  The weather affects each of these industries in different ways.  For example, a warm winter will reduce the profits of an energy producer, whereas a warm summer will produce better grapes wine producers.  In some situations `bad' weather can result in companies making a loss.  For this reason, a number of companies have started trading derivatives to hedge against losses due to weather events, just as one hedges against any price changes on an asset by aquiring an option.  Essentially, this makes a weather derivative rather similar to weather insurance.

What's a weather derivative?

A weather derivative is exactly as it says - a derivative written on the weather.  These can be either swaps, futures or options (most commonly in the form of swaps between two companies).  So how can the weather be treated as an underlying asset you may ask?  Well, the weather is not strictly speaking a physical asset, but just something to base the pricing of the derivatives upon.

The first transactions on weather derivatives took place in the US in winter 1997, after the strongest El Nino event on record.  (The El Nino phenomena has world wide implications on the weather).  The significant coverage of this phenomena by the American press meant companies decided to hedge against losses due to unseasonable weather.  European companies soon followed suit, however,the weather derivatives market in the US is still worth some 10 times more and that of its European counterpart. (This makes the market rather illiquid).

Initially, it was the energy sector that began trading in the weather derivatives market.  By September 1999, with the increase of investors outside the energy sector, the Chicago Mercantile Exchange (CME) started an electronic market for the trading of weather derivatives.

A weather derivative can be written on many different parameters, such as, temperature, rain and snowfall measured at some mutually agreed weather station (e.g. Heathrow, London).  The most common of these being temperature.

To develop a temperature index we start by defining first the temperature on day ,

where and are the maximum and minimum temperatures (in degrees Celsius) recorded at a particular station, respectively.

This will allow us to define the heating degree-days,, and the cooling degree-days,,

and

respectively.

Here 18 is used as a reference point, since it is believed that if the temperature is above (below) 18 people will turn on their air conditioning (heating) and cool down (heat up) their homes, thus a cooling (heating) day.

Most temperature based derivatives as based on the accumulation of or over some period, usually one month or a winter/summer period.

is the accumulated over days.  Similarly,

the accumulated over days.

For example, in the case of a call weather option, a striking level is set and the payout becomes

Here we have used as the amount of money paid out per Degree Day Index (a proportionality constant), known as the tick size.

This makes the pricing of a weather derivative rather like a weather forecasting game, the party with the best forecast better off since they can price their derivatives more appropriately.

Modelling the temperatures statistical behaviour in terms of a stochastic process (Ornstein-Uhlenbeck process) is an essential for temperature derivative pricing.  However, methods used to predict the temperature vary widely.

So why choose weather derivatives over insurance contracts?

The main difference between a weather derivative and contract insurance is that the holder of an insurance contract has to prove that he or she has suffered financial loss as a result of the weather in order to be compensated.  (This is mainly for extreme events such as typhoons and hurricanes).  Weather derivative payouts are depend solely on the outcome of the weather, regardless of how if affects the holders profits.

The weather derivatives market is rapidly growing.

Written by Alessio Farhadi.

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