Finnovation: Weather Derivatives
Weather derivatives are monetary products that derive their values from weather-related variables like temperature, rainfall, snowfall, frost and wind.
BY HARDIK GOEL | 2 MINS Read
Weather derivatives are usually used by organisations to hedge or mitigate the risks related to adverse or unexpected climate. Typical users of weather derivatives include farmers, to hedge against poor harvests caused by frosts or low precipitation, and energy firms that may use weather derivatives to swish earnings caused by unseasonably warm or cool temperatures.
How it works?
Commonly used weather derivatives include futures or options contracts connected to heating degree day (HDD) and cooling degree day (CDD) indices with final pay outs connected to the index. HDDs are calculated as the number of days during a set period, multiplied by the difference within the average temperature (calculated as the median of the day’s high and low temperatures) from eighteen degrees Celsius, that has been determined as the ideal temperature where no heating or cooling is needed. for instance, if the typical temperature measured at the Sydney airport weather station was twelve degrees Celsius on each day in June, then the HDD index for June would be thirty days multiplied by six degrees or 180. CDDs are the reverse, measuring the number of days that cooling or AC may be needed once the typical temperature exceeds eighteen degrees Celsius.
What are weather derivatives usually connected to?
Other weather derivatives are connected to snowfall, rainfall, hurricanes and frosts. hurricane indices embody factors like the number of named hurricanes, wind speed and cyclone radius. Frost derivatives are connected to temperatures at which frosts occur.
Cash, commodities or securities?
Settlement of weather derivatives is usually in money, as opposed to several alternative derivatives where counter parties can physically deliver the underlying commodities or securities at the ending of the contract. The cash settlement price is calculated based on the ultimate price of the HDD, CDD, rainfall, precipitation or hurricane index increased by a particular value, for instance $20 per index point.
In addition to companies and farmers using weather derivatives for risk management, some hedge funds are investing in weather derivatives as some way of generating investment returns that aren't related or connected to alternative asset categories like shares and bonds.
What’s the risk factor?
Because the valuation of weather derivatives isn't simple compared to derivatives connected to other commodity and securities costs, hedge funds will apply refined valuation techniques to undertake to find opportunities within the weather derivatives market. Techniques embody building meteorologic weather forecasting models, looking at prices that firms could also be prepared to pay to “guarantee” climate and looking out at the previous performance of weather derivatives.