What is a Weather Derivative?
The weather derivative is an example of an investment strategy that involves consideration of elements such as wind speed, humidity, temperature, and other weather conditions that could place the investment at a high rate of risk. Like all forms of derivative investments, the weather derivative may involve bonds, equities, and other types of commodities. What is a little different is that the seller charges the buyer of a weather derivative a premium that serves as a safeguard against losses. Many tend to think of a weather derivative as being associated only with high-risk investments that are connected in some manner with severe weather conditions. While it is certainly true that the performance of a weather derivative may be influenced by unexpected weather such as floods or hurricanes, the more common application has to do with temperature fluctuations. Essentially, many weather derivative investments are made based on projections of temperatures on a given day reaching a given ran
It’s a financial instrument that seems like an insurance policy but is more like an option. Most weather derivatives are based on how much the temperature goes above or below 65 degrees. But weather derivatives can be based on anything measurable. Q: Can you give an example? A: A ski area could pay a $250,000 premium to collect, say, $100,000 for every inch of snow this winter under the “strike” amount of 100 inches. This is like a “put” option. The ski area is out the premium whether or not snowfall is inadequate. Or, it could enter into a “swap” with another party, paying no premium and getting $100,000 for every inch under 100 and paying $100,000 for every inch over. Increased ticket sales in good winters would cover the cost. There is also a “call” option where the ski area receives a premium of $250,000 and pays $100,000 for every inch over the strike 100 inches, again assuming higher revenue with heavy snowfall. Q: I understand why companies would hedge against the weather. Why w
Weather derivatives are financial contracts based on an underlying weather index. All weather contracts are based on observations of weather at one or more specific stations. Payments are triggered by adverse weather events according to prespecified conditions. The 10-year-old weather derivative market has reached over US$100 billion in coverage since it began. Up until now, the financial instruments have mainly been used by energy companies to “hedge” or offset lower revenues that result from warm winters. In the case of Malawi, the weather index will be based on a model that estimates maize production using rain fall data. Local weather stations will measure rainfall and the contract will provide a financial payout if severe drought occurs, as per the specified triggers. The first weather derivatives transaction for Malawi will test the market with a small contract that is expected to pay out a maximum of approximately US$3 million if severe drought occurs. Donors are supporting this
It’s a financial instrument that seems like an insurance policy but is more like an option. Most weather derivatives are based on how much the temperature goes above or below 65 degrees. But weather derivatives can be based on anything measurable. Q: An example of weather derivative A: A ski area could pay a $250,000 premium to collect, say, $100,000 for every inch of snow this winter under the “strike” amount of 100 inches. This is like a “put” option. The ski area is out the premium whether or not snowfall is inadequate. Or, it could enter into a “swap” with another party, paying no premium and getting $100,000 for every inch under 100 and paying $100,000 for every inch over. Increased ticket sales in good winters would cover the cost. There is also a “call” option where the ski area receives a premium of $250,000 and pays $100,000 for every inch over the strike 100 inches, again assuming higher revenue with heavy snowfall. Q: Why would anyone assume financial risk by taking the othe
