Explanation of Weather Derivatives

Weather derivatives started as a way to provide insurance for small fluctuations in weather that interrupt daily business cycles. It is a simple fact that the weather, a daily, unpredictable event, has an expounded impact on the business cycle daily. It can alter the amount of spending in a restaurant, the number of tourists in a city, the amount of energy captured by solar panels or even the need for air conditioning. Until recently, companies could hedge the risk of weather-related losses only through insurance plans. These plans covered large, catastrophic events but not daily fluctuations. Weather derivatives cover the smaller, daily fluctuations.

Concept of Weather Derivatives

Few companies rely on their named weather insurance coverage. For example, the policies may kick in only if there is a blizzard, hurricane or other drastic weather event. Far more companies lose money due to small daily fluctuations, even if the amount lost is low. To protect against this, companies began entering into derivatives contracts that tracked weather. If the temperature dropped to, or rose to, a certain named temperature in the options contract, the company could execute the option and cash out to partly cover losses. 

Private Contracts

Weather derivatives arose as private contracts. For example, a private pool needs the temperature to be over 75 degrees to make $300 per day. On any summer day that the temperature does not rise to this amount, the pool loses $300. Insurance does not cover this loss. To make up for the loss, the pool purchases a derivative for 90 days for the small price of $5 each day. The temperature fails to rise to 75 degrees ten times over the summer period, and the pool exercises the option, which pays out $150. Instead of losing $3,000 in profits, the pool loses $1,500. It paid $450 total, for a net loss of $1,950. 

Exchange-Traded Derivatives

While the above example is helpful, a public pool would not typically engage in derivatives. Instead, the contracts were largely privately held between energy companies and private purchasers when they were first introduced. This changed when the Chicago Mercantile Exchange began offering an exchange-traded weather derivative. This meant the options traded just like any other stock, and a large influx of buyers and sellers entered the market. Now, investors can bet on weather based on a daily or monthly index and earn profits based on good bets.

Future of Weather Trading

As companies only recently began engaging in weather derivatives, the market is still fairly limited. The introduction of the exchange-traded metric has increased the market drastically, however. Many analysts believe far more companies will desire weather protection for small-loss, large-risk events. In this case, the market for weather derivatives will continue to expand. As of 2010, the market has already doubled in size twice since the products were first offered for sale. If the trend continues, investing in weather derivatives will become a common technique for both protecting losses and turning a profit.

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