What are weather derivatives?
A weather derivative is a financial instruments which are used to help a company or organisation reduce the risks associated with adverse or unusual weather conditions. They work just like most other derivative contracts except the underlying asset (which is a weather condition such as rainfall, temperature or snowfall) has no value with which to price the derivative contract.
Weather derivatives are used to hedge the risks of inclement weather conditions. They are measurable and essentially triggered by actual weather conditions making them a predictable form of risk management.
Examples of their use could be a ski resort who hedge against the risk that snowfall is too light to allow them to open their slopes (so they buy a snowfall derivative which pays out if snowfall is below a pre defined level), a farmer may buy a weather derivative to hedge against the risks of frost or drought impacting their crops and a power company may hedge against the risks that the weather is warmer than average in winter and their customers don't use their heating as much. Effectively all these examples provide the company buying the derivative wit an opportunity to smooth their earnings over a period of adverse weather which would usually have affected them financially.
Heating degree day and cooling degree day derivative contracts are among the most common types of weather derivatives. The Chicago Mercantile Exchange provides a platform for buyers and sellers of weather derivatives and offer temperature, rainfall, snowfall, frost and hurricane derivatives contracts.
More advanced reading and research on weather derivatives.
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