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WEATHER DERIVATIVES
Copyrights 2010 | Nilanka Sandanayake
Derivatives are types of financial arrangements by which a party earns profits based on functioning of an
underlying asset. 1 If utilised properly, derivatives can be used as a defence for many economic problems
caused by various scenarios such as weather changes.
There are many uses of derivatives in the world of finance. Mainly, hedging is the prominent activity in
which derivatives are largely used. It is a technique developed by the financial world for reducing the risk of
businesses. In this perspective, derivatives can be considered as a form of insurance as well. In addition to
insure or hedge against the risks, derivatives can also be used for acquiring risks.
Although we live in an advanced world full of technology, we still depend on the weather for functioning.
Weather influences our daily life and at large, the economy. Due to the weather impact on corporate
revenues and earnings, 2 especially for energy companies, 3 weather derivatives have been introduced to
the financial markets. By weather derivatives, weather has become a tradable commodity.
There are three main types of derivative contracts between two people or two parties; futures (forwards),
options, and swaps. A futures contract is an agreement between two parties to buy or sell an asset at a
determined time in the future for an agreed price. When it comes to options, it gives the buyer to have the
right to buy, but not the obligation. This way, the seller of the derivative is less protected. Swap is the other
type of derivative that allows the two parties to exchange cash flows in the future according to a pre‐
agreed formula. 4
By looking at the natures of all three types of derivatives, it is evident that swap is the best‐suited
derivative for weather derivatives due to the intangible nature of swap. When weather changes take place,
the two parties can easily exchange the cash flows, without any commodity involved. In addition, swap
allows both parties to profit even if the risk does not get materialised.
Global temperature has been one of the main weather factors affecting the production of agricultural
consumables and energy products. Therefore, it has been the most underlying asset for many hedging
transactions. Let’s take a real example to further explain how weather derivatives work.
If the weather is miserable, people are less likely to hang out in the public with their friends and have a
drink after work. Therefore, a UK wine bar chain, Corney & Barrow Wine Bars Ltd. got into a weather
derivative with another party which paid Corney & Barrow sterling pounds 15,000 ($26,500 approximately)
for each Thursday and Friday that the evening temperature failed to reach 24 degrees Celsius in the
summer of 2001. The temperature is measured by a standard index authorised by the UK authorities. 5
In another example, Dieter Worms who owns a golf club (Gut Apeldor) in Hennestedt, Germany suffered
from serious losses due to the bad weather during 2001. In 2002, he entered into a weather derivative
contract with Societe Generale SA, France’s third largest bank. Worms decided that he could face 50 wet
days per annum. When the number of days with more than 1 mm rain passes 50, the weather derivative
contract started paying Worms compensation for every wet day.5
1
Money Tips, What is a Derivative, viewed 14 May 2010,
<http://money.tips.net/Pages/T005643_What_is_a_Derivative.html>
2
Mikael Haglund, Hedge Fund Trading in Weather Derivatives, viewed 14 May 2010, <www.altevoresearch.com>
3
Carabello, Felix, Introduction To Weather Derivatives, viewed 11 May 2010,
<http://www.investopedia.com/articles/optioninvestor/05/052505.asp>
4
India Business Directory, Types of Derivatives, viewed 14 May 2010, <http://business.mapsofindia.com/investment-
industry/types-of-derivatives.html>
5
Weather Risk Management Association, Weather Derivatives Attract Golf Courses, Utilities, viewed 14 May 2010,
<http://www.wrma.org/wrma/library/file672.doc>