Weather Derivative: Definition, How It Works, Types & Examples

What Is a Weather Derivative?

A weather derivative is a financial instrument used by companies or individuals to hedge against the risk of weather-related losses. The seller of a weather derivative agrees to bear the risk of disasters in return for a premium. If no damages occur before the expiration of the contract, the seller will make a profit—and in the event of unexpected or adverse weather, the buyer of the derivative claims the agreed amount.

Understanding Weather Derivatives

The profitability and revenues of virtually every industry—agriculture, energy, entertainment, construction, travel, and others—depend to a great extent on the vagaries of temperature, rainfall, and storms. Unexpected weather rarely results in price adjustments that entirely make up for lost revenue, making weather derivatives securities that allow companies to hedge against the possibility of weather that might adversely affect their business a pivotal investment for many.

Companies whose business depends on the weather, such as hydroelectric businesses or those who manage sporting events, might use weather derivatives as part of a risk-management strategy. Farmers, meanwhile, may use weather derivatives to hedge against a poor harvest caused by too much or too little rain, sudden temperature swings, or destructive winds.

In 1997, weather derivatives began trading over-the-counter (OTC) and, within a few years, they had become tradeable on an exchange and treated by some hedge funds as an investment class. The Chicago Mercantile Exchange (CME) lists weather futures contracts for a few dozen cities, the majority of them in the U.S.

CME weather futures, unlike OTC contracts, are standardized contracts traded publicly on the open market in an electronic auction type of environment, with continuous negotiation of prices and complete price transparency. Investors who like weather derivatives appreciate their low correlation with traditional markets.

Types of Weather Derivatives

Weather derivatives typically have a basis to an index that measures a particular aspect of weather. For example, an index might be the total rainfall over a specified period in a specific place. Another can be for the number of times the temperature falls below freezing. 

One climate index for weather derivatives is known as heating degree days or HDD. Under HDD contracts, each day the daily mean temperature falls below a predetermined reference point over a specified period, the amount of the departure is recorded and added to a cumulative count. The final figure determines whether the seller pays out or receives payment.

Weather Derivatives vs. Insurance

Weather derivatives are similar to but different from insurance. Insurance covers low-probability, catastrophic weather events such as hurricanes, earthquakes, and tornadoes. In contrast, derivatives cover higher-probability events such as a dryer-than-expected summer.

Insurance does not protect against the reduction of demand resulting from a slightly wetter summer than average, for example, whereas weather derivatives can do just that. Since weather derivatives and insurance cover two different possibilities, a company might have an interest in purchasing both.

Also, since the contract is index-based, buyers of weather derivatives do not need to demonstrate a loss. In order to collect insurance, on the other hand, the damage must be shown.

Weather Derivatives vs. Commodity Derivatives

One important point that differentiates utilities/commodity derivatives (power, electricity, agricultural) and weather derivatives is that the former set allows hedging on price based on a specific volume, while the latter offers to hedge the actual utilization or the yield, independent of the volume.

For instance, one can lock the price of X barrels of crude oil or X bushels of corn by buying oil futures or corn futures, respectively. But getting into weather derivatives allows hedging the overall risk for yield and utilization.

A temperature dipping below 10 degrees will result in complete damage to wheat crop, whereas rain on weekends in Las Vegas will impact city tours. Hence, a combination of weather and commodity derivatives is best for overall risk mitigation.