Weather Derivatives

Financial innovation can be defined as the process of creating and then popularizing new financial products, services, processes and technologies.

E.g. Hedge funds, derivatives, Private equity, ATM, Multi-family offices etc.

BY SAHIL DESAI | 2 Mins Read

The Emerging Market of Weather Derivatives

Weather derivatives are financial instruments used by organizations or individuals as part of a risk management strategy to reduce risk associated with adverse or unexpected weather conditions. They derive their values from variables such as temperature, rainfall, snowfall, frost and wind.

For example the market for snow-related weather derivatives is huge during the Christmas. Snowfalls which often go together with Christmas can affect lots of businesses in the form of snowstorms. These blizzards can cause huge economic damage worth billions of dollars. The contracts are priced based on the expected inches of snow in a particular time period in a given city. If accumulation is greater than the set amount, the buyer of the derivative claims the agreed amount. But if the snowfall is less than that figure, the seller will make a profit.

When it all started?

The first transactions relating to weather derivatives were undertaken in 1997 in the US. The international financial market didn’t take much time to realize that if they are able to quantify weather in terms of monthly or seasonal variations and put a price tag on each variation from the average, then they could very easily trade changes in weather just like any financial instrument.

The Chicago Mercantile Exchange of the US created the first exchange-traded weather futures contracts and options on futures in 1999 based on the index of monthly variations in daily city temperature.

Uses

• Typical users of weather derivatives include agriculture, tourism and travel, entertainment, construction and energy sector.
• Farmers can use weather derivatives to hedge against poor harvests caused by low or excessive rainfall.
• During Christmas a ski resort can hedge against the risk that snowfall is too light to allow them to open their slopes (so they buy a snowfall derivative which pays out if snowfall is below a pre defined level).
• Theme parks may want to insure against rainy weekends during peak summer seasons.
• A sports event managing company may wish to hedge the loss by entering into a weather derivative contract because if it rains the day of the sporting event, fewer tickets will be sold.
• Effectively all these examples provide the company buying the derivative an opportunity to smooth their earnings over a period of adverse weather which could have affected them financially.

Weather Derivatives: Need of the Hour

It is estimated that more than 80% of all business activities in the world are dependent on weather in some way or the other. Weather affects corporations and SME’s as it impacts corporate revenue and earnings, decision making and increases the risk for the business.

There can be as many types of weather derivatives as there are types of weather conditions. These weather derivatives are becoming very popular in international financial markets which now have become an $8 billion industry in just few years.

Weather derivatives are not traded in India but now it is high time Indian exchanges too have derivatives on weather, to help farmers, consumers, corporates and even insurance companies.

The product will taste real success if this financial innovation is available across the world.