Why weather derivatives?
Weather (temperature, snowfall, sunshine, rainfall) affects volume and usage of certain businesses such as utility and energy companies but the use of weather derivatives is much wider. End-users include other commercial businesses which revenues may be adversely affected by unexpected weather patterns e.g. a soft drink manufacturer may for example wish to purchase protection against a cooler than usual summer.
The use of weather derivatives is therefore to hedge against the risk of excessive costs or depressed demand arising from something that a business cannot control or predict with precision and consistency. Unlike other derivatives, weather derivatives are not used to hedge the price of the underlying (as the weather cannot be priced) but rather a proxy to hedge against risks that arise because of weather conditions.
Insurance can be used to protect against weather risk but usually is more expansive and covers catastrophic damage but cannot usually protect against loss of profit caused by weather. In other words, insurance covers high risk, low probability event whereas weather derivatives cover low risk but high probability events. Insurance also requires proof of damages or loss but not weather derivatives. Weather derivatives contracts can also be transferred or assigned with greater ease than insurance contracts.
What are weather derivatives?
There are two types of weather derivatives contracts: (a) exchange-traded and (b) privately negotiated, over-the-counter agreements between counterparties.
Exchange-trade weather futures and options on futures are standardised contracts traded publicly on the open market. These can be based on specific indices that reflect average temperatures of US, European and Asian (Japan) cities. OTC weather derivatives are often documented under ISDA documentation. ISDA published the new 2005 Commodity Definitions on 30 June 2005. The 2005 definitions cover weather derivatives as well as other commodity products (such as power, natural gas and emissions).
These indices could be, for example, tied to an index of ‘heating degree day’ (during the winter month) and ‘cooling degree day’ (for the summer month) compiled by data published by governmental or meteorological agencies. The HDD, for example, is calculated by reference to an average temperature of a day (e.g. 65°F in the US and 18°C in Europe and Japan). In Europe for the summer months, the Cumulative Average Temperature (CAT) is also used. In Japan, the Japan Weather Derivatives Index (JWDI) covers the cities of Tokyo, Osaka and Nagoya and provides data on HDD, CDD, average temperature and precipitation days.
The monthly HDD or CDD value is aggregate of all daily HDD or CDD, and seasonal values are the accumulated values for the winter or summer months.
In a typical weather derivatives transaction, the buyer of protection pays a premium to the seller in return for an agreement by the seller to pay the buyer an amount determined by reference to an index on a specific date or dates if the index is above or below certain levels.
Issues in weather derivatives
Weather is localised so the weather at the relevant place may not be the same of the place at which measurement is taken e.g. the rainfall at the weather station may be different from that experienced by a vineyard because of distance or other geographic conditions.
Underlying of weather derivatives is not a traded good so pricing is usually based on actuarial calculations and not universal pricing method.
Last updated 19 June 2006^
The above notes are intended to provide only general outlines and should be read in conjunction with, and are qualified in their entirety by, the full provisions of the relevant ISDA provisions and definitions. They should never be used in place of professional advice. We accept no responsibility for any loss arising from any action taken or not taken by anyone using this material or using this material in conjunction with any ISDA documentation in reliance thereof.
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