Weather Forecasting for Weather Derivatives



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



More intriguing information

1. THE WELFARE EFFECTS OF CONSUMING A CANCER PREVENTION DIET
2. Regional Intergration and Migration: An Economic Geography Model with Hetergenous Labour Force
3. FUTURE TRADE RESEARCH AREAS THAT MATTER TO DEVELOPING COUNTRY POLICYMAKERS
4. Running head: CHILDREN'S ATTRIBUTIONS OF BELIEFS
5. Voluntary Teaming and Effort
6. Analyzing the Agricultural Trade Impacts of the Canada-Chile Free Trade Agreement
7. Credit Market Competition and Capital Regulation
8. PERFORMANCE PREMISES FOR HUMAN RESOURCES FROM PUBLIC HEALTH ORGANIZATIONS IN ROMANIA
9. Public-private sector pay differentials in a devolved Scotland
10. Improvements in medical care and technology and reductions in traffic-related fatalities in Great Britain
11. Psychological Aspects of Market Crashes
12. The name is absent
13. The name is absent
14. Nach der Einführung von Arbeitslosengeld II: deutlich mehr Verlierer als Gewinner unter den Hilfeempfängern
15. The name is absent
16. The Demand for Specialty-Crop Insurance: Adverse Selection and Moral Hazard
17. A Critical Examination of the Beliefs about Learning a Foreign Language at Primary School
18. Nonlinear Production, Abatement, Pollution and Materials Balance Reconsidered
19. The name is absent
20. Making International Human Rights Protection More Effective: A Rational-Choice Approach to the Effectiveness of Ius Standi Provisions