Planning for a rainy day—understanding weather derivatives

Planning for a rainy day—understanding weather derivatives

How can businesses utilise weather derivatives to protect themselves from adverse weather events? Joanna Perkins of South Square Chambers looks at the development of weather derivatives and their role in managing risk.

What exactly are weather derivatives?

Fluctuations in seasonal weather can pose a challenge to a wide spectrum of businesses whose performance is sensitive to the prevailing patterns. The weather risk market is designed to assist users in managing the adverse financial impact of weather through risk transfer instruments based on weather variables (temperature, rain, snow, wind, etc). To enter into a weather derivative, an enterprise pays a premium to a risk taker who assumes the risk of adverse weather. In exchange for the premium, the risk taker will promise to pay the buyer an amount of money corresponding to the anticipated loss occasioned by the adverse weather. Standardised derivatives, such as futures, will reference published risk indices calculated from contemporary weather data (such as temperature or precipitation). The purchase price, or premium, will correlate broadly to the perceived chance of the risk materialising and the relevant probabilities will be calculated from historic data. In this respect, weather derivatives are analogous to other ‘adverse event’ derivatives, such as credit default swaps. They also share features with more traditional forms of protection, such as insurance.

How have weather derivatives developed since they were first used?

The first over-the-counter (OTC) weather derivatives trades took place in 1997, involving Willis, Koch Industries, and Enron. Two years later, the Chicago Mercantile Exchange (CME) introduced exchange-traded weather futures and options. At the launch of these standardised products, two temperature contracts—Heating Degree Days (HDDs) and Cooling Degree Days (CDDs)—were listed for trading. These contracts were monthly futures and options reflecting the accumulated differences between the average daily temperature and a base temperature of 65°F for each day in a calendar month. Given that exposure to weather risks is normally

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About the author:

Meet Emma:

1.Banking and finance lawyer with experience in derivatives, debt capital markets, securitisation and structured finance in London and Paris

2.Likes ballet, playing the harp and holidays

3.Thinks the law is always changing!

Emma trained and qualified at Allen & Overy LLP and worked in their derivatives and structured finance teams in London and Paris.  She then joined the foreign exchange prime brokerage legal team at Deutsche Bank before spending 4 ½ years with Crédit Agricole CIB advising the fixed income and derivatives desk.