In this post I’ll try to make a brief introduction to weather derivatives in the form of Q&A. I will try to answer with simple words the ten most common questions related to weather derivatives. Read below the first part.
1) What is a Weather Derivative?
Weather derivatives are financial instruments that can be used by organizations or individuals as part of a risk management strategy to reduce risk associated with adverse or unexpected weather conditions. Just as traditional contingent claims, whose payoffs depend upon the price of some fundamental, a weather derivative has an underlying measure such as rainfall, temperature, humidity, or snowfall.
2) What is the difference between Weather Derivatives and traditional financial derivatives?
The difference from other derivatives is that the underlying asset has no value and it cannot be stored or traded (for example a stock or a commodity like gold) while at the same time the weather should be quantified in order to be introduced in the weather derivative. To do so, temperature, rainfall, precipitation, or snowfall indices are introduced as underlying assets.
3) What type of events do Weather Derivatives cover?
In general, weather derivatives are designed to cover non-catastrophic weather events. Rainy or dry and warm or cold periods which are expected to occur frequently can cause large fluctuation on the revenues of a particular company. A company that uses weather derivatives as a part of its hedging strategy can eliminate the risk related to weather.
4) So, does weather affect the economy?
Nearly $1 trillion of the US economy is directly exposed to weather risk. It is estimated that nearly 30% of the US economy and 70% of the US companies are affected by weather.
5) Who uses Weather Derivatives?
Today, weather derivatives are being used for hedging purposes by companies and industries, whose profits can be adversely affected by unseasonal weather or, for speculative purposes, by hedge funds and others interested in capitalizing on those volatile markets.
If you have any more question leave them as comments and I’ll try to reply to them or gather them together and answer them in a new post.
If you are interested in learning more about weather derivatives and the weather market you can start by reading: Alexandridis, A. and Zapranis, A. (2013). Weather Derivatives: Modeling and Pricing Weather-Related Risk. New York, USA: Springer.