Abstract

WRITUM.CO
M
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

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>
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