weather derivatives are financial instruments that can be used by organizations or individuals as part of a risk management strategy to reduce risk associated with adverse or unexpected weather conditions .

weather derivatives are index-based instruments that usually use observed weather data at a weather station to create an index on which a payout can be based .

this index could be total rainfall over a relevant period - which may be of relevance for a hydro-generation business - or the number where the minimum temperature falls below zero which might be relevant for a farmer protecting against frost damage .

unlike " indemnity " insurance-based cover , there is no need to demonstrate that a loss has been suffered .

settlement is objective , based on the final value of the chosen weather index over the chosen period .

if a payout is due , it is usually made in a matter of a few days with the settlement period being defined in the contract : unlike insurance contracts , there is no " loss adjustment " process . see exotic derivatives .

weather derivative

figure 1 - a weather derivative table quoting prices of may 2005 contracts . source : chicago mercantile exchange weather - i™ .
a weather derivative is a futures contract - - or options on that futures contract - - where the underlying commodity is a weather index .
keep up with the latest weather derivatives and weather risk management news on our blog .
a weather derivative is a financial instruments which are used to help a company or organisation reduce the risks associated with adverse or unusual weather conditions . they work just like most other derivative contracts except the underlying asset ( which is a weather condition such as rainfall , temperature or snowfall ) has no value with which to price the derivative contract .
covers the meteorological , statistical , financial and mathematical issues that arise in the pricing and risk management of weather derivatives . written by consultants who work within the weather derivative industry , this book is packed with practical information and theoretical insight into the world of weather derivative pricing .
a derivative is a financial contract that gets its value from an underlying asset . options offer one type of common derivative . read answer > >
a . zapranis and a . alexandridis , “modelling and forecasting cat and hdd indices for weather derivative pricing , ” in
weather derivatives - modeling and pricing weather - related risk | antonis alexandridis k . | springer
a selection of articles and research papers on weather derivatives and weather risk pricing and structuring .
a weather derivative is a financial instrument used by companies or individuals to hedge against the risk of weather - related losses . the seller of a weather derivative agrees to bear the risk of disasters in return for a premium . if no damages occur before the expiration of the contract , the seller will make a profit . in the event of unexpected or adverse weather , the buyer of the derivative claims the agreed amount .
originally published in 2005 , weather derivative valuation covers all the meteorological , statistical , financial and mathematical issues that arise in the pricing and risk management of weather derivatives . there are chapters on meteorological data and data cleaning , the modelling and pricing of single weather derivatives , the modelling and valuation of portfolios , the use of weather and seasonal forecasts in the pricing of weather derivatives , arbitrage pricing for weather derivatives , risk management , and the modelling of temperature , wind and precipitation . specific issues covered in detail include the analysis of uncertainty in weather derivative pricing , time - series modelling of daily temperatures , the creation and use of probabilistic meteorological forecasts and the derivation of the weather derivative version of the black - scholes equation of mathematical finance . written by consultants who work within the weather derivative industry , this book is packed with practical information and theoretical insight into the world of weather derivative pricing .
originally published in 2005 , weather derivative valuation covers all the meteorological , statistical , financial and mathematical issues that arise in the pricing and risk management of weather derivatives . there are chapters on meteorological data and data cleaning , the modelling and pricing of single weather derivatives , the modelling and valuation of portfolios , the use of weather and seasonal forecasts in the pricing of weather derivatives , arbitrage pricing for weather derivatives , risk management , and the modelling of temperature , wind and precipitation . specific issues covered in detail include the analysis of uncertainty in weather derivative pricing , time - series modelling of daily temperatures , the creation and use of probabilistic meteorological forecasts and the derivation of the weather derivative version of the black - scholes equation of mathematical finance . written by consultants who work within the weather derivative industry , this book is packed with practical information and theoretical insight into the world of weather derivative pricing . show more
weather derivatives are financial instruments that can be used for risk management purposes to hedge against losses due to adverse , unpredictable weather . in contrast to other derivative products , the underlying asset - such as frost , rain , temperature and wind - has no direct value with respect to the price of the weather derivative .
m . cao and j . wei , “weather derivatives valuation and market price of weather risk , ”
s . d . campbell and f . x . diebold , “weather forecasting for weather derivatives , ”
m . cao and j . wei , “pricing the weather . risk weather risk special report , ”
the party that sells a weather derivative bears this risk for a premium and stands to earn a profit if the weather remains relatively stable , predictable or normal . if the weather does turn bad , then the party that purchases the derivative claims the agreed upon amount . as one would expect , temperature is the most commonly used underlying weather factor , 18 degrees celsius ( 65 degrees fahrenheit ) is a standard baseline from which deviations are measured , but any other measurable weather - related event can be used as an underlying factor for a weather derivative .
a spatial approach to addressing weather derivative basis risk : a drought insurance example nick d . paulson and chad e . hart jul 2006
a credit derivative is a financial asset in the form of a privately . . .
nobel weather associates helps companies protect against the negative impact that weather can have on their expenses and revenue .
speedwell weather is a uk - based firm that provides world - wide weather data , forecasts , software and consulting services to the energy and weather derivative markets . the firm is a recognized leader in the weather markets , with a strong following in europe and a growing presence in other parts of the globe .
weather derivatives are used to hedge the risks of inclement weather conditions . they are measurable and essentially triggered by actual weather conditions making them a predictable form of risk management .
in 1997 , the first over - the - counter ( otc ) weather derivative trade took place , and the field of weather risk management was born . according to valerie cooper , former executive director of the weather risk management association , an $ 8 billion weather derivatives industry developed within a few years of its inception .
current users of weather futures are primarily companies in energy - related businesses . however , there is growing awareness and signs of potential growth in the trading of weather futures among agricultural firms , restaurants and companies involved in tourism and travel . many otc weather derivative traders also trade cme weather futures for purposes of hedging their otc transactions .
even in our advanced , technology - based society , we still live largely at the mercy of the weather . it influences our daily lives and has an enormous impact on corporate revenues and earnings . until recently , there were very few financial tools offering companies protection against weather - related risks . however , the inception of the weather derivative —making weather a tradeable commodity—has changed all this . here we look at how the weather derivative was created , how it differs from insurance and how it works as a financial instrument .
investors who sell weather derivatives agree to take on the risk for a premium . investors will profit from these transactions if weather conditions remain normal . if the weather changes unexpectedly , the company that bought the derivative collects an agreed - upon amount . to trade these products market participants will use weather forecasts to predict how the weather conditions will affect the current and future market . weather market players are from a variety of industries and other participants include hedge funds , institutional firms , and brokers .
weather derivative is a new risk management tool which can be widely used in the financial market to avoid the impact of bad weather effects and control the weather risks . the first weather derivative was introduced in the us in 1997 and the size of the market now exceeds 8 billion dollars . weather derivatives are different from traditional financial derivatives as their underlying asset such as temperature , humidity , and precipitation , which cannot be traded in the market , so ordinary pricing models such as black and scholes formula is not applicable in pricing weather derivatives . as a consequence , the valuation of weather derivatives is generally carried out in a lot of paperwork . weather derivatives can be based on any meteorological index , such as temperature , rain , wind , and snow , while the most commonly used weather variable is the temperature .
heating degree day and cooling degree day derivative contracts are among the most common types of weather derivatives . the chicago mercantile exchange provides a platform for buyers and sellers of weather derivatives and offer temperature , rainfall , snowfall , frost and hurricane derivatives contracts .
china’s climate varies drastically because the country is large , and weather events affect the profits of many of its industries . as a new risk management instrument , weather derivative market is developing rapidly . so the introduction of weather derivatives can bring significant benefits to various weather - affected industries in china . as weather is not a tradable asset , it is a relatively complicated task to make a “fair” pricing model for them . in order to enable the weather derivative market and bring significant benefits to various weather - affected industries in china , it is essential for the new market , especially in china , that a transparent and reliable approach to pricing is put in place so that the participants can feel secure in their transactions .
protection against undesirable weather events , like , for instance , hurricanes and droughts , has been offered by insurance companies . in the recent decades , the securitization of such weather insurances has taken place , and nowadays one can trade weather derivative contracts at the chicago mercantile exchange ( cme ) , or more specialized weather contracts in the otc market . at the cme , one finds derivatives written on temperature and snowfall indices , measured at different locations worldwide . the market for weather derivatives is emerging and gaining importance as a tool for hedging weather risk .
stephen jewson works for a financial consultancy where he manages a group that produces commercial software and meteorological data for the weather derivative industry . he has published a large number of articles in the fields of fundamental climate research , applied meteorology and weather derivatives . show more
as the underlying asset of the weather derivative is non - tradeable these instruments cannot be priced in the same way as more traditional derivatives . there is no standard model for valuing weather derivatives similar to the widely used black - scholes formula that is used to price many equity options and similar derivatives . as such they are more prone to modelling risk than other types of derivative products .
weather is determined by an independent historical weather provider . julia receives money if there is any rain ( more than zero ) on her wedding day !
weather derivatives , developed in the 1990s , fill an unmet need in the economy . the weather impacts roughly 20 % of the u . s . economy . agriculture , energy , travel , and construction are examples of industries in which weather plays an especially important role . but unexpected weather rarely results in price adjustments which entirely make up for lost revenue . weather derivatives allow companies to hedge against the possibility of weather that might adversely affect their business .
in 1997 , weather derivatives began trading over - the - counter ( otc ) , and within a few years , they had become an $ 8 billion industry . the chicago mercantile exchange ( cme ) lists weather derivative contracts for a few dozen cities , the majority of them in the u . s . some hedge funds treat weather derivatives as an investment class . investors who like weather derivatives appreciate their low correlation with traditional markets .
asc 815 - 10 notes that it
defines derivative instrument , addresses the pervasive scope of this topic , and specifies the primary accounting for derivative instruments within this topic ' s scope .
it further notes the following information regarding the entire 815 topic :
learn about weather derivatives , a financial instrument that makes temperature a tradable commodity .
analysts look at historical weather patterns - - temperature , rainfall and other things - - develop averages , and quantify the risk that weather will deviate from the average .
weather derivatives are different from insurance , because they ' re linked to common weather events , like dry seasons , or a warm autumn , that affect particular businesses .
asc 815 - 45 provides guidance on the financial accounting and reporting for weather derivatives .
a derivative security in which an investor hedges against the future state of the weather . for example , two investors may enter a weather derivative , where one investor pays the other if rainfall in a given place over a given period of time is above a certain amount . likewise , the other investor pays if the rainfall is below the agreed - upon amount . one of the most common weather derivatives is a weather future , in which the buyer is required to pay the seller $ 20 for each day in a given month that the daily temperature is below 65 degrees ( a heating degree day ) or above 65 degrees ( a cooling degree day ) , depending on the nature of the contract . a weather future allows a business to hedge against potential losses resulting from an unexpected change in weather . energy companies are some of the most common sellers of weather derivatives .
examples of their use could be a ski resort who hedge against the risk that snowfall is too light to allow them to open their slopes ( so they buy a snowfall derivative which pays out if snowfall is below a pre defined level ) , a farmer may buy a weather derivative to hedge against the risks of frost or drought impacting their crops and a power company may hedge against the risks that the weather is warmer than average in winter and their customers don ' t use their heating as much . effectively all these examples provide the company buying the derivative wit an opportunity to smooth their earnings over a period of adverse weather which would usually have affected them financially .
weather derivatives are financial instruments that can be used by organizations or individuals as part of a risk management strategy to minimize risk associated with adverse or unexpected weather conditions . just as traditional contingent claims , a weather derivative has an underlying measure , such as : rainfall , wind , snow or temperature . nearly $ 1 trillion of the u . s . economy is directly exposed to weather - related risk . more precisely , almost 30 % of the u . s . economy and 70 % of u . s . companies are affected by weather . the purpose of this monograph is to conduct an in - depth analysis of financial products that are traded in the weather market . presenting a pricing and modeling approach for weather derivatives written on various underlying weather variables will help students , researchers , and industry professionals accurately price weather derivatives , and will provide strategies for effectively hedging against weather - related risk . this book will link the mathematical aspects of the modeling procedure of weather variables to the financial markets and the pricing of weather derivatives . very little has been published in the area of weather risk , and this volume will appeal to graduate - level students and researchers studying financial mathematics , risk management , or energy finance , in addition to investors and professionals within the financial services industry .
a . zapranis and a . alexandridis , “wavelet analysis and weather derivatives pricing , ” in
j . svec and m . stevenson , “modelling and forecasting temperature based weather derivatives , ”
a . swishchuk and k . cui , “weather derivatives with applications to canadian data , ”
doing something about weather : weather derivatives have helped companies control financial risk for nearly a decade . now that they ' re trading on a mercantile exchange , sales are really taking off
e . platen and j . west , “a fair pricing approach to weather derivatives , ”
in fact , it is more important that the model is statistically significant for weather derivative pricing . we compare the predicted values obtained by our stochastic model with 100 , 000 simulations to the actual observations for zhengzhou over year 2013 ( see figure
mda earthsat is the premier source of specialized weather products for global weather risk analysis . users of these products include such varied industries as energy , food , retail , insurance , banking , and government . our products appeal to anyone who must manage and minimize their weather risk .
learn why most exchange - traded funds ( etfs ) are not considered derivative securities and the special circumstances when this . . . read answer > >
swiss re announced that it has entered into a weather derivative contract with the international development association ( ida ) , the arm of the world bank that helps the world ' s poorest countries . under the terms of the contract , swiss re will pay out up to usd 5 million in the event that malawi ' s farmers suffer from a drought - related shortfall in maize production . with this transaction , the ida backs its first - ever weather derivative contract with the government of malawi .
a broad range of weather derivative products are available including options , futures , forwards and swaps . most are traded over - the - counter ( otc ) although there are some traded electronically on indexes like the chicago merchantile exchange ( cme ) . the cme offers weather derivative products that “offers trading opportunities related to temperatures , snowfall , frost and hurricanes . the products are based on a range of weather conditions in more than 47 cities in the united states , europe , canada , australia and asia , with the hurricane products geared to nine us regions . ” ( cme group 2011 ) [ 1 ]
this weather derivative contract is just one instrument as part of a world bank effort to deliver customized financial solutions and help members plan efficient responses to catastrophic events . the use of weather derivatives are most effective as part of a broader risk management strategy ,
said gloria grandolini , director of the world bank treasury ' s banking and debt management department .
weather derivatives are usually structured as swaps , futures , and options based on different underlying weather indexes . some commonly used indices are hdd , cdd , precipitation , wind , and snowfall . for the sake of clarity , we focus our analysis on derivative products whose underlying is the level of cumulated daily temperatures over a given period , the hdd and cdd .
international business machines corp . ( ibm ) subsidiary the weather company will move its headquarters to atlanta .
h . geman and m . - p . leonardi , “alternative approaches to weather derivatives pricing , ”
m . moreno , “riding the temp , ” weather derivatives , fow special supplement , december 2000 .
insurance is still required to protect against major weather events , like tornadoes , hurricanes , and floods .
nobel weather associates uses patented risk management tools and internal company data to manage the affect that weather has on your cash flows . the program has been proven throughout the united states . regardless of your exposure , nobel weather’s strategies will be tailored to meet the specific needs , circumstances and risk tolerance of each client .
in 2008 , volume skyrocketed with the launching of otc weather auctions [ 3 ] . not only has temperature - based weather volume grown , but other weather products have also seen success . business in the cme group hurricane products - now in their second year of trading - has increased dramatically . also , two new online exchanges - stormexchange and weatherbill - have driven the weather derivatives market from mainly energy traders to a whole new set of end - users . both firms have been successful in speaking to end - user traders that are affected by day - to - day weather conditions . these firms have been successful in educating and monatizing their weather risk and structuring over - the - counter weather deals that are customized to their needs .
getting a
weather waiver
when a storm threatens can save your trip – and your travel budget .
f . dornier and m . queruel , “caution to the wind . weather risk special report , ” in
in 1999 , the chicago mercantile exchange ( cme ) took weather derivatives a step further and introduced exchange - traded weather futures and options on futures—the first products of their kind . otc weather derivatives are privately negotiated , individualized agreements made between two parties . but cme weather futures and options on futures are standardized contracts traded publicly on the open market in an electronic auction type of environment , with continuous negotiation of prices and complete price transparency .
swiss re has pioneered weather risk transfer instruments in developing countries , starting in india in 2004 with a programme reaching over 350 000 smallholder farmers . in the meantime , the company has become a leading solution provider in weather and weather contingent commodity price structures with a share of more than 30 % in the worldwide weather risk markets . under its climate adaptation and public sector business development programmes , the company fosters the use of modern risk management instruments , such as weather derivatives and insurance - linked securities , to the benefit of non - oecd countries .
companies whose business depends on the weather , such as hydro - electric businesses or those who manage sporting events , might use weather derivatives as part of a risk - management strategy . farmers may use weather derivatives to hedge against a poor harvest caused by too much or too little rain , sudden temperature swings , or destructive winds .
to learn more about how you can change the way weather impacts you call ( 781 ) 783 - 3207 .
p . alaton , b . djehiche , and d . stillberger , “on modelling and pricing weather derivatives , ”
weather derivatives are financial instruments that can be used by organizations or individuals as part of a weather risk management strategy to reduce risk associated with adverse or unexpected weather conditions . farmers can use weather derivatives to hedge against poor harvests caused by drought or frost ; theme parks may want to insure against rainy weekends during peak summer seasons ; and gas and power companies may use heating degree days ( hdd ) or cooling degree days ( cdd ) contracts to smooth earnings .
in this study , a unified approach to pricing is established for the weather derivative marketplace , and we mainly worked on a stochastic modeling to describe the behavior of the temperature choosing as underlying for the hdd call weather derivative . through taking zhengzhou , for example , we establish a stochastic model by the 62 - year historical temperatures in zhengzhou and use the monte carlo method for the hdd call pricing . the model describing the stochastic behavior of the temperature is validated on the basis of temperatures observed during year 2013 . as shown by the monthly evolved relative errors , the proposed mean - reverting ornstein - uhlenbeck model can reasonably describe daily temperature data of zhengzhou in the aspects of the mean , volatility , and mean reverting speed . therefore , the mean - reverting ornstein - uhlenbeck model , on the basis of 62 year of data of temperature , in zhengzhou , enabled us to simulate a temperature weather derivative contract .
f . perez - gonzales and h . yun , “risk management and firm value : evidence from weather derivatives , ”
f . e . benth and j . šaltytė benth , “the volatility of temperature and pricing of weather derivatives , ”
m . moreno and d . bari , “temperature stochastic modelling and weather derivatives pricing : empirical study with moroccan data , ”
m . mraoua and d . bari , “temperature stochastic modeling and weather derivatives pricing : empirical study with moroccan data , ”
in general , weather derivatives cover low - risk , high - probability events . weather insurance , on the other hand , typically covers high - risk , low - probability events , as defined in a highly customized policy . for example , a company might use a weather derivative to hedge against a winter forecasters think will be 5° f warmer than the historical average ( a low - risk , high - probability event ) . in this case , the company knows its revenues would be affected by that kind of weather . the same company would also most likely purchase an insurance policy for protection against damage caused by a flood or hurricane ( high - risk , low - probability events ) .
weather derivatives are similar to but different from insurance . insurance covers low - probability , catastrophic weather events such as hurricanes , earthquakes , and tornados . in contrast , derivatives cover higher - probability events such as a dryer - than - expected summer .
corporations use weather derivatives to hedge their risk that bad weather will cause a financial loss . for a cereal company , bad weather might be a drought , which would cause wheat prices to go up . for a home heating company , it could be warm days in november , which could lower demand for home heating oil . and for an amusement park it could be rain .
in order to avoid excessive payouts on the contract due to extreme weather , the options often come with the maximum payoff . suppose
as a result of the affect of normal variations and extreme or catastrophic events of weather and climate , a growing number of businesses and government entities are seeking out methods to manage their exposure to weather risk , which include the use of derivatives , insurance products and changes in their operations . this course provides a comprehensive and technical treatment of the valuation and risk management of weather derivatives .
one climate index for weather derivative is known as heating degree days or hdd . under hdd contracts , each day the daily mean temperature falls below a predetermined reference point over a specified period , the amount of the departure is recorded and added to a cumulative count . the final figure determines whether the seller pays out or receives payment .
the weather derivative contract with the world bank is a prime example of an ex - ante disaster risk management strategy designed to mitigate the financial impact of drought for a country such as malawi that is heavily dependant upon the income from its agricultural production ,
said juerg trueb , swiss re ' s head of environmental and commodity markets .
insurance does not protect against the reduction of demand resulting from a slightly wetter summer than average , for example , but weather derivatives can do just that . since weather derivatives and insurance cover two different possibilities , a company might have an interest in purchasing both .
weather derivatives typically have a basis to an index which measures a particular aspect of weather . for example , an index might be the total rainfall over a specified period in a specific place . another can be for the number of times the temperature falls below freezing .
f . e . benth and j . saltyte - benth , “stochastic modelling of temperature variations with a view towards weather derivatives , ”
f . e . benth and j . šaltyte - benth , “stochastic modelling of temperature variations with a view towards weather derivatives , ”
a preliminary assessment of the utility of seasonal forecasts for the pricing of u . s . temperature based weather derivatives risk management solutions 2004
asu 2016 - 05 , effect of derivative contract novations on existing hedge accounting relationships — a consensus of the fasb emerging issues task force ( issued march 2016 ; effective december 15 , 2016 , for public entities ) .
the value of a cme weather futures contract is determined by multiplying the monthly hdd or cdd value by $ 20 . in the example above , the cme november weather contract would settle at $ 4 , 160 ( $ 20 x 208 = $ 4 , 160 ) .
in the late 1990s , people began to realize if they quantified and indexed weather in terms of monthly or seasonal average temperatures and attached a dollar amount to each index value , they could in a sense
package
and trade weather . in fact , this sort of trading would be comparable to trading the varying values of stock indices , currencies , interest rates and agricultural commodities . the concept of weather as a tradeable commodity , therefore , began to take shape . ( for related reading , see : how do you trade the weather ? )
until recently , insurance has been the main tool used by companies for protection against unexpected weather conditions . but insurance provides protection only against catastrophic damage . insurance does nothing to protect against the reduced demand businesses experience as a result of weather that is warmer or colder than expected .
a . zapranis and a . alexandridis , “modelling the temperature time - dependent speed of mean reversion in the context of weather derivatives pricing , ”
b . dischel , “black - scholes won ' t do . weather risk special report , ” energy and power risk management , october 1998 .
we use the monte carlo method to generate a set of paths and for each of these paths we calculate the payoff . then , the average of the payoffs from all the generated paths will represent the expected price of the derivative .
asc 815 - 15 provides guidance for embedded derivatives that may be included in
[ c ] ontracts that do not in their entirety meet the definition of a derivative instrument , such as bonds , insurance policies , and leases .
to our knowledge , little literature has been developed for the temperature model of henan province , which is the most important state granary in china and is also a major financial market of china . in order to ensure food security , it is necessary to transfer the weather risk of henan province into financial markets through developing weather derivatives . so the main objective of our research is to take the first step to construct weather models for developing weather derivatives in henan province . we construct a temperature model for the first time for zhengzhou ( see figure 1 ) , which is the capital of henan province .
brockett et al . [ 8 ] applies the indifference pricing approach in a mean - variance setting to valuate weather derivatives . davis [ 12 ] introduces the marginal utility approach to pricing of weather derivatives , which is based on hedging in correlated assets and modelling of the index as a geometric brownian motion . platen and west [ 13 ] suggest using a world index as a benchmark for weather derivatives pricing . equilibrium theory has also been a popular approach for pricing weather derivatives . cao and wei [ 14 ] apply this to analyse us temperature futures ( see also hamisultane [ 15 ] for a more recent study ) .
the daily average temperature is calculated by averaging each day’s maximum and minimum temperature from midnight - to - midnight . given a weather station , let us note by
a . zapranis and a . alexandridis , “weather derivatives pricing : modelling the seasonal residuals variance of an ornstein - uhlenbeck temperature process with neural networks , ” in
p . l . brockett , m . wang , c . c . yang , and h . zou , “portfolio effects and valuation of weather derivatives , ”
the risks businesses face due to weather are somewhat unique . weather conditions tend to affect volume and usage more than they directly affect price . an exceptionally warm winter , for example , can leave utility and energy companies with excess supplies of oil or natural gas ( because people need less to heat their homes ) . or an exceptionally cold summer can leave hotel and airline seats empty . although the prices may change somewhat as a consequence of unusually high or low demand , price adjustments don ' t necessarily compensate for lost revenues resulting from unseasonable temperatures . ( for related reading , see : what impact does weather have on my investment in the weather industry ? )
get access to recent and historical weather settlement data for active and recently expired contracts in the u . s . , canada , europe , asia , and austrailia .
it is estimated that nearly 20 % of the u . s . economy is directly affected by the weather , and the profitability and revenues of virtually every industry—agriculture , energy , entertainment , construction , travel and others—depend to a great extent on the vagaries of temperature . in a 1998 testimony to congress , former commerce secretary william daley stated ,
weather is not just an environmental issue , it is a major economic factor . at least $ 1 trillion of our economy is weather - sensitive .
here , we should mention that the temperature of the physical formation process is extremely complex , especially for complex regional climates of china ; the study on the technical design temperature option is not enough and still worthy of more in - depth theoretical exploration and practices . we should develop more weather models for each geographic region for the weather derivative market in china . in addition , it is also necessary to further develop more precise temperature models for weather derivatives pricing . many other mathematical tools , such as wavelet functions , b - spline functions , and polynomial function , can be used for a more accurate modeling of temperature data . it would be interesting to treat carefully the jumps of temperatures due to extreme phenomena by integrating a term which describes their behavior within the stochastic model . this will make it possible to improve the performance of the daily scale modeling . in the end , we emphasize that it is also important to construct accurate weather models for other weather factors , such as the rain , the snow , or the fog , since the risks implied by these factors also deeply affect economic development of china .
the main users of weather derivatives are energy companies as demand for their products can vary drastically due to extreme weather conditions . the agricultural industry is the second main user of such instruments although other purchasers include firms arranging major sporting ( outdoor ) events and even tour operators . hedge funds are reputedly also major investors in this alternative asset class .
you can buy weather derivatives as an individual , but you ' ll want to consider the trading costs carefully to ensure that your risk of loss is worth the expense .
w . härdle and b . lopez cabrera , “infering the market price of weather risk , ” discussion paper , sfb 649 , humboldt - universität zu berlin , 2009 .
for european cities , cme ' s weather futures for the hdd months are calculated according to how much the day ' s average temperature is lower than 18° celsius . however cme weather futures for the summer months in european cities are based not on the cdd index but on an index of accumulated temperatures , the cumulative average temperature ( cat ) .
the weather derivatives market trades both over - the - counter ( otc ) , through brokers , and over an exchange , cme group . however , there is a direct interplay between these two marketplaces . weather trades are very often confirmed otc , and then
given up
to the cme for clearing . in this case , counterparties strike a bi - lateral transaction using a broker then process the trade through the cme , using established credit facilities to speed execution . [ 1 ] . the major weather brokers are :
we focus on catastrophe bonds , insurance - linked securities , alternative reinsurance capital , insurance & reinsurance linked investments . we also cover life , weather risk and longevity risk transfer .
the cereal company and the amusement park might buy futures contracts with an underlying weather index based on rainfall . the home heating company might want contracts based on a temperature index .
finally , weather risk is also unique in that it is highly localized , cannot be controlled and , despite great advances in meteorological science , still cannot be predicted precisely and consistently .
the weather market has grown tremendously over the last few years and participants trade over - the - counter and exchange - listed products at cme . the first weather derivative deal was in july 1996 when aquila energy structured a dual - commodity hedge for consolidated edison co ( con ed ) . the transaction involved coned ' s purchase of electric power from aquila for the month of august . the price of the power was agreed to , but a weather clause was embedded into the contract . this clause stipulated that aquila would pay coned a rebate if august turned out to be cooler than expected . the measurement of this was referenced to cooling degree days measured at new york city ' s central park weather station . if total cdds were from 0 to 10 % below the expected 320 , the company received no discount to the power price , but if total cdds were 11 to 20 % below normal , con ed would receive a $ 16 , 000 discount . other discounted levels were worked in for even greater departures from normal [ 2 ] .
explanation : here is an explanation in the case of weather insurance , which basically says that such analysis applies past experience to current positions , as your own text indicates .
burn rate
generally refers to the rate at which something like a contract ( or maybe an insurance reserve ) for example is consumed . burn analysis burn analysis is the simplest form of weather derivative pricing . it involves taking historical values for the index ( which may be based on raw , cleaned , or enhanced data , and which may have been detrended in some way ) and applying the financial contract to them . depending on the quality of the data used to calculate the historical indices used , burn analysis may give a useful first indication of the mean and range of possible payouts of a weather derivative contract , and can be done simply in a spreadsheet . the disadvantages of burn analysis are that it may not capture the possible extremes and may be unduly influenced by individual years in the historical record . it can also not be extended easily to analyse a portfolio of contracts . i am also pretty sure no insurance company would ever refer to
burn rate
in reference to fire insurance .
also , since the contract is index - based , buyers of weather derivatives do not need to demonstrate a loss . in order to collect insurance , on the other hand , damage must be shown .
we present our findings as follows . in the next section we review the basics of the cme market for weather derivatives . next , in section 3 , our temperature model with seasonal stochastic volatility is defined and analysed . section 4 contains results on the futures price dynamics for some commonly traded products at the cme . some empirical considerations of our model and its applications to weather derivatives are presented in section 5 .
shane joined nobel weather associates in 2010 at its inception under the name snowcast solutions . during that time , he has been focused on developing the analytics , product capabilities , and patent expansion . ( continue reading )
this is the first book to cover all the meteorological , statistical , financial , and mathematical issues that rise in pricing and risk management of weather derivatives . abstracts of public administration , development , and the environment
in contrast to the various outlooks provided by government and independent forecasts , weather derivatives trading gave market participants a quantifiable view of those outlooks ,
noted agbeli ameko , managing partner of energy and forecasting firm enercast .
the remainder of the paper is organized as follows . we introduce the basic concepts of weather derivative in section 2 . section 3 proposes a seasonal mean and volatility model that describes the daily average temperature behavior using the mean - reverting ornstein - uhlenbeck process . the unknown parameters of the process will be estimated with 62 years of daily average temperature from zhengzhou ( 57083 ) meteorological station . then we discuss the pricing model of hdd option based on the temperature forecasting model and price the hdd option with monte carlo simulation in section 4 . section 5 explains findings of our research and contains concluding remarks .
the main purpose of this paper is to present a feasible model for the daily average temperature on the area of zhengzhou and apply it to weather derivatives pricing . we start by exploring the background of weather derivatives market and then use the 62 years of daily historical data to apply the mean - reverting ornstein - uhlenbeck process to describe the evolution of the temperature . finally , monte carlo simulations are used to price heating degree day ( hdd ) call option for this city , and the slow convergence of the price of the hdd call can be found through taking 100 , 000 simulations . the methods of the research will provide a frame work for modeling temperature and pricing weather derivatives in other similar places in china .
broadly speaking , cme weather futures and options on futures are exchange - traded derivatives that , by means of specific indexes , reflect monthly and seasonal average temperatures of 15 u . s . and five european cities . these derivatives are legally binding agreements made between two parties and settled in cash . each contract is based on the final monthly or seasonal index value determined by earth satellite ( earthsat ) corp , an international firm specializing in geographic information technologies . other european weather firms determine values for the european contracts . earthsat works with temperature data provided by the national climate data center ( ncdc ) , and the data it provides is used widely throughout the over - the - counter weather derivatives industry as well as by cme .
asc 815 , derivatives and hedging , provides comprehensive guidance on derivative and hedging transactions . it sets forth the definition of a derivative instrument and specifies how to account for such instruments , including derivatives embedded in hybrid instruments . in addition , asc 815 establishes when reporting entities , in certain limited , well - defined circumstances , may apply hedge accounting to a relationship involving a designated hedging instrument and hedged exposure . hedge accounting provides an alternative , special way of accounting for such relationships . asc 815 also provides guidance on how reporting entities determine whether an instrument is ( 1 ) indexed to the reporting entity’s own stock and ( 2 ) considered to be settled in the reporting entity’s own stock . such a determination will dictate whether an instrument should be accounted for as debt or equity and the appropriate accounting for the instrument . finally , asc 815 addresses the accounting for non - exchange - traded weather derivatives . the codification also provides certain industry - specific derivatives and hedging guidance , but such guidance is included in the industry sections of the codification .
the advantages of these products are becoming increasingly known : the trading volume of cme weather futures in 2003 more than quadrupled from the previous year , totaling roughly $ 1 . 6 billion in notional value , and the momentum of this volume continues to increase .
when not managing a weather derivatives exchange , i am a senior business analyst / consultant helping businesses organize and develop digital solutions to reduce operational & regulatory risk . i specialize in specifying requirements for large data integration projects for capital markets , custody and risk management .
mr . noyes founded nobel weather associates under its original name , snowcast solutions , in 2010 . this new business leveraged bill’s trading experience and was spawned while running mac’s property maintenance services , a regional snow removal company in the chicago area . ( continue reading )
list of figures list of tables acknowledgements 1 . weather derivatives and the weather derivatives market 2 . data cleaning and trends 3 . the valuation of single contracts using burn analysis 4 . the valuation of single contracts using index modelling 5 . further topics in the valuation of single contracts 6 . valuation of single contracts using daily methods 7 . modelling portfolios 8 . managing portfolios 9 . introduction to meteorological forecasts 10 . the use of meteorological forecasts in pricing 11 . arbitrage pricing models 12 . risk management 13 . modelling non - temperature data appendices references index .
temperature futures may be used by energy producers to hedge their demand risk ( see perez - gonzales and yun [ 7 ] for a study of weather hedging of us energy utilities ) . other typical users of such futures contracts for hedging purposes are electricity retailers , holiday resorts , producers of soft drinks and beer , or even organisers of outdoor sport events , and fairs . also investors have seen the potential in weather derivatives as a tool for portfolio diversification , since the derivatives are not expected to correlate significantly with the financial markets ( see brockett et al . [ 8 ] ) .
list of figures ; list of tables ; acknowledgements ; 1 . weather derivatives and the weather derivatives market ; 2 . data cleaning and trends ; 3 . the valuation of single contracts using burn analysis ; 4 . the valuation of single contracts using index modelling ; 5 . further topics in the valuation of single contracts ; 6 . valuation of single contracts using daily methods ; 7 . modelling portfolios ; 8 . managing portfolios ; 9 . introduction to meteorological forecasts ; 10 . the use of meteorological forecasts in pricing ; 11 . arbitrage pricing models ; 12 . risk management ; 13 . modelling non - temperature data ; appendices ; references ; index . show more
a classical approach that was used to derive the price of a temperature derivative is the performing of simulations based on historical data , known as hba ( history burn analysis ) . hba is very easy to calculate since there is no need to fit the distribution of the temperature or to solve stochastic differential equations . however , this method can only price the contract roughly since the assumption is not correct usually . it is apparent that the temperature time series is not stationary but contains seasonality , jumps , and trends [ 1 – 4 ] , so this method is bound to be biased and inaccurate .
since temperature exhibits strong and clear seasonality , the mean - reverting o - u process is proposed in most weather derivatives literature . dischel [ 15 ] argued that the classical black - scholes - merton pricing approach cannot be directly applied in weather derivatives pricing . he is the first person who proposed a continuous stochastic model in temperature forecasting . dornier and queruel [ 16 ] use a more general arma model than the ar ( 1 ) model proposed by [ 17 ] , where benth and saltyte - benth fitted norwegian data by modeling the dat variations with a mean - reverting process where the noise process is modeled by a generalized hyperbolic levy process . instead of the fbm used in their previous work , they expanded the work of dornier and queruel . in order to rectify the rejection of the normality hypothesis , zapranis and alexandridis [ 18 ] replaced the simple ar ( 1 ) model by more complex ones . their results from the dat in paris indicate that , as the model gets more complex , the noise part draws away from the normal distribution . swishchuk and cui [ 19 ] applied two daily average temperature models to canadian cities data and derived their derivative pricing applications . göncü [ 20 ] proposes a seasonal volatility model that estimates daily average temperatures of beijing , shanghai and shenzhen using the mean - reverting ornstein - uhlenbeck process and then derive analytical approximation formulas for the sensitivities of these contracts . their results verify the convergence of the monte carlo and approximation estimators .
weather contracts on u . s . cities for the winter months are tied to an index of heating degree day ( hdd ) values . these values represent temperatures for days when energy is used for heating . the contracts for u . s . cities in the summer months are geared to an index of cooling degree day ( cdd ) values , which represent temperatures for days on which energy is used for air conditioning . both hdd and cdd values are calculated according to how many degrees a day ' s average temperature varies from a baseline of 65° fahrenheit ( the day ' s average temperature is based on the maximum and minimum temperature from midnight to midnight ) .