How do you trade the weather?

Weather affects our daily lives and large enterprises, and brings significant benefits and risks based on the variability of weather factors such as temperature, wind, rainfall, and snowfall. Germanwatch cited that between 1997 and 2016, the United States experienced a loss of 0.255%. The unit of GDP affected by weather. In order to reduce the risk of destructive weather factors, weather derivatives have been greatly welcomed.

This article discusses the use of weather derivatives, the differences between them and related commodity derivatives, the operation of various weather derivatives, and who is the leader in the field of weather derivatives.

Use of weather derivatives

The following scenarios illustrate the use of weather derivatives:

  • Energy companies can enter weather derivatives to eliminate the risk of uncertainties in the supply and demand of electricity, utilities, and energy businesses due to temperature changes.
  • In order to eliminate the risk of reduced crop production due to bad weather, agricultural companies can sign derivative contracts, which include heavy or light rain, unfavorable temperature conditions, or the effects of strong wind or snow.
  • Event management organizations (such as sports organization companies, tourism and tourism companies, or open-air theme parks) conduct hedging to reduce the negative impact of rain on their event business.
  • Insurance companies, hedge funds and even the government trade weather derivatives for hedging purposes
  • Speculators, arbitrageurs and market makers look for speculative betting or arbitrage opportunities under weather conditions
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Utilities, energy and power companies are important participants in the weather derivatives market.

Examples of weather derivatives and how they work

  • Weather derivatives were introduced between two parties as over-the-counter products in the mid-1990s, mainly as terms of conditions (for example, if the temperature exceeds “Z” degrees, one party will provide the other party’s “Y” dollars in its transaction Rebates). They quickly became popular and were classified by exchanges as easy-to-tradable futures, options, swaps, and futures contract options.
  • Today, CME Group offers location-specific weather derivatives-American cities such as Des Moines or Las Vegas, and global cities in Europe and Asia-products for specific temperatures.
  • Weather derivatives quantify the degree to which the temperature of a specified city/region differs from the monthly or seasonal average. These changes are scaled by a dollar-weighted index to quantify the dollar value of temperature changes.
  • According to the 65° F (18° C in Europe) set temperature threshold set in the United States, the contract is linked to the heating degree days (HDD) and cooling degree (CDD) indexes. These values ​​represent the amount of available resources required for heating or cooling. If the temperature is lower than the threshold, which means 35° F for heating, the HDD value is 30 (65-35) and the CDD value is zero because cooling is not required. For temperatures above this 65° F threshold, for example at 85° F, the HDD will be zero because heating is not required, and the CDD value is 20 (85-65).
  • By multiplying the HDD or CDD value by $20, each contract is valued for each day (or month). For the first case (HDD = 30 and CDD = 0), the HDD contract value is $600 and the CDD is zero. For the second case (HDD = 0 and CDD = 20), the HDD contract value is zero and the CDD contract value is 400 USD.
  • Using the above mechanism, people can take appropriate trading positions to reduce the temperature-specific risks perceived by their respective businesses.
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Weather and commodity derivatives

An important point to distinguish between utility/commodity derivatives (electricity, electricity, agriculture) and weather derivatives is that the former allows price hedging based on a specific quantity, while the latter provides a hedge against actual utilization or revenue, independent of volume. For example, you can lock in the price of X barrels of crude oil or X bushels of corn by buying oil futures or corn futures, respectively. But entering weather derivatives can hedge the overall risk of production and utilization. Temperatures below 10 degrees will cause complete damage to the wheat crops; rain in Las Vegas on weekends will affect city tours. Therefore, the combination of weather and commodity derivatives is most suitable for mitigating the overall risk.

Bottom line

The weather derivatives market has developed and grown on a global scale, with a large amount of investment from various participants. Weather instruments are a useful medium for mitigating risks in specific weather conditions.According to needs, you can use specific weather derivatives or a balanced combination of weather and traditional commodity derivatives for hedging

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