A weather derivative is a financial product that corporations or individuals use to protect themselves against weather-related losses. In exchange for a premium, the seller of a weather derivative accepts the risk of calamity. The seller will make a profit if no damage occurs before the contract expires, while the buyer of the derivative claims the agreed sum if unexpected or severe weather occurs. Unlike traditional weather insurance, which pays out based on a proven loss ("indemnification"), a weather derivative pays out based on a weather index ("parametric"). For example, utilizing information from a single weather reference site or a basket of sites, the index could be millimeters of rainfall or cumulative temperature. Most weather contracts are over the counter ("OTC") arrangements tailored to a specific business's vulnerability. Many businesses could be disrupted by losses caused by climate change. According to Pierre Saint-Laurent, a full-time finance lecturer at HEC Montréal and a member of the Canadian Derivatives Institute, climate change affects about one-third of global GDP. Agriculture, tourism, and transportation are among the most severely impacted industries. Weather derivatives were initially traded in the late 1990s.
Enron Corp. and Koch Energy Trading discovered that the weather derivatives is a high risk even for investors who love taking risk, when they attempted to sell $332 million in weather bonds, a new high-risk instrument. Koch and Enron were at the lead of a completely fresh new industry in weather derivatives, which are investments that move the risk of weather-related losses from corporations to investors prepared to take on the risks in exchange for potentially significant returns. The first weather derivative contract was created by Koch and Enron, and it was dependent on how cold the 1997-1998 winter would be. Enron promised to pay Koch $10,000 for every degree the temperature fell below average, and Koch committed to pay Enron $10,000 for every degree the temperature rose over normal.
The Chicago Mercantile Exchange (CME) launched the first exchange-traded, temperature-related weather futures and options on September 22, 1999, to expand the size of the weather derivatives market and eliminate the counter-party credit risk associated with over-the-counter weather contracts. Large and small investors can use the CME contracts to hedge their weather-related risks using liquid, standardized contracts, with the added benefit of always having access to the best available prices. The CME Clearing House decreases counter-party credit risk by insuring both parties' performance in a weather futures or options contract, which is a significant advantage of the CME's exchange-traded contracts. The CME Clearing House serves as both a buyer and a seller for every vendor.
Weather derivatives are comparable to insurance, but they are not the same. Hurricanes, earthquakes, and tornadoes are examples of low-probability, severe weather disasters that are covered by insurance. Derivatives, on the other hand, cover higher-probability situations like a drier-than-expected summer. In the EU, weather derivatives are now significantly less popular than insurance plans. However, in today's climate, they are regarded excellent tools for hedging against the risk associated with weather unpredictability, and they may become even more appealing in future climates characterized by higher variability and frequency of catastrophic weather. It is possible to create a pay-out proportional to the magnitude of the unfavorable weather phenomenon using a weather derivative. The index-based nature of weather derivatives ensures complete transparency. There is no loss-adjustment process, therefore settlement is generally quicker than with traditional insurance.
Pricing of weather derivatives is not easy and hence brokers have utilized a variety of actuarial, financial economics, and meteorological techniques to analyze the data and subsequently calculate a fair price, including Correlation and regression analysis, De-trended time series, Burning cost, Scenario testing and Monte Carlo simulations, Black-Scholes derivative pricing, and Seasonal weather forecasting. To price weather derivatives, most brokers take the assistance of a team of experts that includes actuaries, financial mathematicians, statisticians, and climatologists. For example, Long-term weather forecasting is of limited utility in relation to European weather patterns, and as a result, European pricing strategies owe more to the statistical than the meteorological domain.
Hedging in weather derivative, a corporation has a lot of options. Heating Degree Day is the most common choice for dealing with winter temperature risk, whereas Cooling Degree Day is the most common option for dealing with summer temperature risk. The HDD Index is a measurement of the cold waves that occur during the winter months. The HDD index is determined by subtracting the mean of the daily high and low temperatures from 65 degrees Fahrenheit (in the US) or 18 degrees Fahrenheit (in the UK). The colder the day, the higher the index value. The CDD Index is a metric that evaluates how hot it is throughout the summer. The CDD index is determined by subtracting 18 degrees Celsius from the daily mean of high and low temperatures. The higher the index value, the warmer the day.
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