Weather futures are derivative contracts where the payoffs are based on the aggregate difference in a measured weather variable, such as temperature or precipitation, over a fixed period.
What are Derivative Contracts?
Derivative contracts are financial instruments whose value is derived from the performance of underlying assets, indices, or rates. In the context of weather futures, the underlying asset is a specific weather condition.
Components of Weather Futures
Underlying Weather Variables
Weather futures can be based on various weather metrics:
- Temperature: Degrees Celsius or Fahrenheit averaged over a specific period.
- Precipitation: Measured in millimeters or inches.
- Wind Speed: Average or peak velocities.
Contract Terms
Contracts define specific periods (days, months) and locations (cities, regions) where the weather variable is measured.
How Weather Futures Work
Weather futures involve the following steps:
- Contract Initiation: Investors or businesses purchase weather futures contracts based on predicted weather conditions.
- Measurement Period: The weather is monitored over the contract’s specified period.
- Settlement: At the end of the measurement period, the difference between actual weather data and the predetermined baseline is calculated. Payoffs are determined based on this difference.
Examples of Weather Futures
- Temperature-Based Contracts: An energy company might buy a weather future to hedge against unusually warm winter temperatures that could reduce heating demand.
- Precipitation-Based Contracts: Agricultural businesses might use precipitation futures to hedge against insufficient rainfall that could impact crop yields.
Historical Context
Weather futures emerged in the late 20th century as a way for businesses to hedge against weather-related risks. The Chicago Mercantile Exchange (CME) began offering weather futures contracts as demand for more sophisticated risk management tools grew.
Applicability in the Financial Market
Weather futures are used by various sectors:
- Energy Companies: To hedge against demand variability.
- Agricultural Producers: To protect against unfavorable weather conditions.
- Retailers: To safeguard sales during critical seasons.
- Insurance Firms: To manage payout risks related to weather events.
Comparisons with Related Terms
Weather Options
Unlike futures, weather options provide the right but not the obligation to trade based on weather conditions.
Catastrophe Bonds
These bonds provide payoffs when triggered by specific weather disasters, unlike weather futures, which deal with more routine weather conditions.
FAQs
Who can trade weather futures?
Are weather futures similar to traditional futures contracts?
References
- Chicago Mercantile Exchange. “Weather Futures and Options.”
- Global Risk Insights. “The Emergence of Weather Derivatives.”
Summary
Weather futures are sophisticated financial instruments that allow businesses to hedge against weather variability. They are valuable in sectors where weather impacts operational outcomes, providing stability and predictability amid climatic uncertainties.
