Weather derivatives: How the farmer´s risk reduction can be the trader´s gain

We humans have always wanted to minimize our exposure to unfavorable weather events. We moved into caves, we made ourselves clothes to protect us from the elements and we carried out elaborate sacrifices to the Gods of the Storm and the Gods of the Harvest to keep them on our side.

Eventually, we began creating rather complex insurance and welfare systems. And then, in 1996, the first weather derivative was created, and within a year, people were trading weather derivatives over-the-counter. Soon, the need to mitigate weather risk had become the foundation for profitable trading. Peter´s eagerness to reduce his exposure to bad weather had turned into a nice opportunity for Paul to make money by trading in instruments that shifted that risk around.

In recent years, weather derivatives have become increasingly popular among direct investors looking for non-correlated items to manage risk in porfolios that chiefly contain items from more traditional financial markets. Before, weather derivative investments were chiefly a field occupied by fund of funds investors.


Who uses weather derviatives?

Weather derivatives are chiefly used by businessess who wish to manage their exposure to adverse weather events.

Here are a few examples:

  • Farmers and agricultural corporations can use weather derviatives to handle risks associated with factors such as excessive rains during the growth or harvest season, unfavorable temperatures, damaging winds, and droughts.
  • Gas companies can use weather derivatives to handle the swings broughts on by temperature changes. Both heating degree days (HDD) derivatives and cooling degree days (CDD) derivatives are available. Such derivatives are also popular among corporations who sell electricity for heating and cooling use.
  • Open-air theme parks and sporting arenas can use weather derivatives to mitigate the impact of rainy weekends keeping visitors away.

No proof of loss is required

Weather derivatives differ from standard insurance policies in several notable ways. One of them is that a standard weather insurance policy will require proof of loss in order to pay out, while a weather derivative will pay out as soon as conditions are met.

Example: A farmer with a weather insurance policy must prove that the unusually cold month damaged his potatoes and caused an economic loss. A farmer will a weather derivative will get paid simply because the month was cold (as meassured in accordance with the weather derivative contract) – there is no need to prove a loss.

The trailblazing Chicago Mercantile Exchange

The Chicago Mercantile Exchange (CME) has been imperative in the development of exchange-traded weather derivatives. They launched the first exchange-traded weather futures contracts and corresponding options in 1999, and currently lists weather derivatives for various cities in North America (35 cities), Europe (11 cities), Japan (3 cities) and Australia (3 cities).

A majority of the weather derivatives listed on the CME track cooling or heating degree days, but you can also find derivatives based on factors such as rainfall or snowfall.

The CME Hurricane Index provides contracts based on a formula derived from named storms in the United States. It has become an important tool for the re-insurance industry.

Understanding weather derivatives

It is difficult to fully grasp the nature of weather derivatives without know how they came about and how the trade in weather derivatives has developed over the years. We will therefore take a brief look at the history of weather derivatives, with a special focus on the United States.

The creation of the first weather derivative

The first weather derivative deal was completed in July 1996 when Aquila Energy structured a dual-commodity hedge for Consolidated Edison (ConEd). The focus of the contract was ConEd´s coming purchase of electricity from Aquila Energy for the month of August.

  • The contract included both the price of the electricity and a weather clause.
  • The weather clause obliged Aquila to give ConEd a rebate if August was cooler than expected. This in turn would be determined based on the number of Cooling Degree Days (CDDs) measured at the Central Park weather station in New York City.
  • The expected CDDs for August were 320. If the total CDDs turned out to be 0-10% below this, there would be no rebate. If the total number of CDDs was more than 10% above the expectation but not over 20%, the rebate would be $16,000. For higher deviations from the expected, other discount levels would come into effect.

Trading in weather derivatives

It did not take long for traders to become interested in weather derivatives. In 1997, trading was already going on, and in 1999 the Chicago Mercantile Exchange (CME) launched the first exchange-traded weather futures contracts and corresponding options.


Valuation of weather derivatives

There is no standard model available for valuing weather derivatives. The underlying ”asset” of a weather derivative is typically not tradeable, and it is therefore not possible to use the Black-Sholes formula.

As a result of this, weather derivatives are valued using various models, and there is no consensus. A valutation used in one context might not be approved in another.