Weather Derivatives

Basically, derivatives are risk sharing tools. These are used by investors, businesses and institutions. Each derivative is valued on the basis of its underlying asset or variable. These assets or variables could be stock, commodity or even the temperature at a place. Farmers can hedge the decline in the prices of wheat. Airlines can manage aviation fuel costs. Exporters seek protection against currency swings. Strictly speaking, these are financial instruments, and yet they serve an economic purpose. They transfer risk from those who bear it to others who are willing to take it.

There are well-designed weather-derivative contracts. These reduce uncertainty and support long-term investments.

Weather becomes tradeable when it is location-specific, measurable, time-bound and independently verifiable. It should be reduced to a number agreed upon by both the parties before trade. At the time of settlement both the parties accent it without dispute. The most commonly used weather variables are :

Temperature: Here Heating Degrees days (HDD) and Cooling Degree Days (CDD) are measured indices. They track how much daily weather deviates from a set base.

Rainfall: The contracts are structured on cumulative rainfall, say total mm over a month in a district, or deviations from long-term averages.

Snowfall or Wind Speed: It is common in advanced markets with exposure to ski tourism construction or wind energy projects.

Trading of Weather Phenomena

These are not traded as weather events but are traded as numerical outcomes. To illustrate, a rainfall futures contract might pay Rs.7000 per mm shortfall if the actual rainfall in Sawan drops-below the 100 mm threshold in Satara. The data source is agreed upon beforehand.

There are informal markets which operate on weather cues. These are instinctive. Weather derivatives structure this.

Using Weather Derivatives

A cold drink company expects a summer surge in sales, but if summer experiences unusually cool weather on account of rain spells undue, there could be a drop in demand. Insurance does not cover this. Here a temperature derivative could help. If May temperature stays below 36-degree centigrade, it creates a cushion to offset lost sales.

Farmers can take rainfall-linked hedge, say a rainfall 30 per cent below average. The derivative then pays. Banks can use rainfall-based hedges against its rain portfolio of loans. Lending then becomes viable.

Well-functioning weather derivatives market enhances credit quality for financial institutions. There is risk resilience.

Insurance vs. Derivative

When the loss is catastrophic, insurance is more helpful than a derivative, say damages to a warehouse on account of storm or floods destroying inventory. Derivatives are suited for non-catastrophic, recurring risks, say low rainfall or cooler temperatures. These affect revenues but not assets. Insurance safeguards property. Derivatives shield cash flows.