1. Introduction
Weather derivatives are a fascinating new type of security, making pre-specified payouts if pre-
specified weather events occur. The market has grown rapidly. In 1997, the market for weather derivatives
was nonexistent. In 1998 the market was estimated at $500 million, but it was still illiquid, with large
spreads and limited secondary market activity. More recently the market has grown to more than $5
billion, with better liquidity. Outlets such as the Weather Risk (e.g., 1998, 2000) supplements to Risk
Magazine have chronicled the development.
Weather derivative instruments include weather swaps, options, and option collars; see, for
example, volumes such as Geman (1999) and Dischel (2002) for definitions and descriptions. The payoffs
of these instruments may be linked to a variety of “underlying” weather-related variables, including heating
degree days, cooling degree days, growing degree days, average temperature, maximum temperature,
minimum temperature, precipitation (rainfall, snowfall), humidity and sunshine, among others - even the
National Weather Service's temperature forecast for the coming week. Most trading is over-the-counter,
but exchange-based trading is gaining momentum. Temperature-related derivatives, for example, are
actively traded on the Chicago Mercantile Exchange (CME) for major U.S. cities.
A number of interesting considerations make weather derivatives different from “standard”
derivatives. First, the underlying object (weather) is not traded in a spot market. Second, unlike financial
derivatives, which are useful for price hedging but not quantity hedging, weather derivatives are useful for
quantity hedging but not necessarily for price hedging (although the two are obviously related). That is,
weather derivative products provide protection against weather-related changes in quantities,
complementing extensive commodity price risk management tools already available through futures.
Third, although liquidity in weather derivative markets has improved, it will likely never be as good as in
traditional commodity markets, because weather is by its nature a location-specific and non-standardized
commodity, unlike, say, a specific grade of crude oil.
Interestingly, weather derivatives are also different from insurance. First, there is no need to file a