Definition
Weather derivatives allow businesses to hedge against adverse weather conditions that affect revenue or costs. Common structures use heating degree days (HDD) or cooling degree days (CDD) as the underlying index. Unlike insurance (which covers extreme events), weather derivatives can cover any deviation from normal conditions, providing smoother earnings for weather-sensitive businesses.
lightbulb Example
A utility company buys an HDD call for winter, paying $500K premium. If heating degree days exceed 4,000, the company receives $10K per HDD above 4,000. A mild winter (3,800 HDD) means the option expires worthless; a harsh winter (4,500 HDD) pays $5M.
verified_user Key Points
- Based on measurable weather indices (HDD, CDD, rainfall)
- Hedges revenue or cost exposure to weather
- Different from insurance—covers any deviation, not just extremes
- Agricultural, energy, and tourism sectors are primary users