Weather Derivatives: Raining on Your Sunny Day

The weather derivative is a unique form of investment that has not been around forever. With the weather derivative, you can essentially bet on what the weather is going to do. Here are the basics of the weather derivative and how it works.

Background

The weather derivative was created as a way for companies to hedge their bets against the weather. Many people do not stop to think about how much the weather affects businesses and the economy. According to some estimates, the weather affects as much as $1 trillion of the economy every year. Although our society is very technologically advanced, much of it still depends on the randomness of the weather.

Many financial professionals sought a device that would allow them to speculate on the weather. This would allow companies to protect themselves against the randomness of the weather and level out their profits. In 1997, the first weather derivative was traded. Since that point, weather derivatives have become increasingly popular in the investment world. Every year, more and more investors are choosing to trade in weather derivatives.

How They Work

At first glance, the idea of trading the weather might seem a bit confusing. In order to do this, you have to be able to quantify the weather. With weather derivatives, temperature is recorded and indexed. It is kept track of in a monthly or seasonal system. For example, the temperature is averaged over the course of a month and then compared to what was predicted with the derivative. A derivative might specify that the investor believes that the average temperature of an area will be 4 degrees higher than the past average for this time of year.

Exchange Traded

Weather derivatives have advanced to become exchange traded securities. In 1999, the Chicago Mercantile Exchange made it possible for investors to easily trade weather derivatives over an exchange. This made it much more possible for the average investor to get involved with weather derivatives. Today, they are very easy to access through online exchanges.

Compared to Weather Insurance

Many people may not understand the difference between weather derivatives and weather insurance. However, there are a few key differences between these two items. Weather insurance is designed to protect businesses against things that rarely happen. For example, you would need to buy weather insurance in order to protect your business against a tornado or a hurricane. With weather derivatives, you are protecting your business against more long-term negative impacts from weather. For example, if you know that an average temperature of 5 degrees above normal would negatively impact your business over the course of a season, then purchasing weather derivatives might be in your best interest.

Using Weather Derivatives

Energy companies work with weather derivatives more than any other single entity. However, they have become more popular with individual investors recently. Other companies are also starting to realize the value of purchasing weather derivatives to protect business interests.

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