RELEVANCE OF WEATHER DERIVATIVES

RELEVANCE OF WEATHER DERIVATIVES

In recent times, weather derivatives have become an increasingly important and standard financial instrument to hedge against weather risks. They essentially function to transfer risks from one entity to another.?

Weather derivatives can be applied across various industries and regions to help organizations mitigate the financial impact of weather-related events. It is particularly useful to agricultural commodity firms which are acutely exposed to weather.

As the relevance of weather derivatives grows, new technologies are being developed to make them more accessible and simpler to trade. Take for example, blockchain-based platforms have been developed to trade derivatives more efficiently and transparently, which could help drive wider adoption.

Let’s take a look at some common examples of weather derivative trades which are mainly executed in the US, Australia and Europe:

1.Heating Degree Day (HDD) Derivatives

HDD is a measure of the amount of heating required in a particular location. It is calculated as the difference between the average daily temperature and a reference temperature (usually 65°F).

A trader can enter into an HDD derivative contract that pays out if the number of HDDs in a particular location during a specific time?is above or below a pre-agreed threshold.

Example:

Utility companies could purchase a HDD derivatives to protect against lower-than-expected demand for natural gas for heating requirements during winter.

2.Cooling Degree Day (CDD) Derivatives

CDD is a measure of the amount of cooling required in a particular area. It is calculated as the difference between the average daily temperature and a reference temperature (usually 65°F).

A trader can enter into a CDD derivative contract that pays out if the number of CDDs in a particular region during a specific time period is above or below a predetermined threshold.

Example:

An electricity company for instance could purchase CDD derivatives to protect against higher-than-expected demand for electricity for air conditioning purposes in the summer.

3.Temperature Derivatives

A trader can enter into a temperature derivative agreement that pays out based on the average temperature in a particular location during a specified time.

Example:

A retailer could buy a temperature derivative to protect against lower-than-expected sales of seasonal merchandise due to colder temperatures.

4.Precipitation Derivatives

A trader can enter into a precipitation derivative contract that pays out based on the amount of rainfall or even snowfall in a region during a specific time interval.

Example:

An agricultural company could buy a precipitation derivative to protect against losses due to drought or excess rainfall. Or a mining company could buy a rainfall derivative to protect against losses due to excessive rainfall that could affect production.

5.Wind Derivatives

A trader can enter into a wind derivative contract that pays out based on the wind speed or direction in a particular region during a specific time period.

Example:

A renewable energy company might buy wind derivatives to protect against lower-than-expected wind speeds which would reduce electricity production from wind turbines.

6.Solar Radiation Derivatives

A trader can enter into a solar radiation derivative contract that pays out based on the amount of sunlight received in a particular region during a specific time period.

Example:

A solar power company could buy a solar radiation derivative to protect against lower-than-expected electricity production due to cloud cover.

7.Crop Yield Derivatives:

A trader can enter into a crop yield derivative contract that pays out based on the yield of a specific crop in a particular region during a specific time period.

Example:

A farmer might buy a crop yield derivative to protect against losses due to drought or excess rainfall.

Apart from these examples highlighted, many other types of weather derivative contracts can be customized to fit specific weather-related risks.

In Asia, weather derivatives are slowly but steadily getting attention. India is known to be susceptible to weather-related events and calls have been made for the introduction of weather derivatives to help reduce the impact of on the economy. More recently, China’s Guangdong Provincial Government has announced plans to assist the Guangdong Futures Exchange in exploring the potential of weather futures. However, Southeast Asian countries generally still lag behind when it comes to the use of weather derivatives.

Without doubt, weather derivatives are vital for managing climate risks and protection against the financial impact of severe and unpredictable weather events. Their relevance will only grow as the effects of climate change become more pronounced. Business will not be as usual.