Weather Derivatives – What are they, where are they traded and how are they priced?
Recently, global financial markets have witnessed a rapid escalation in the popularity and the trading of weather derivatives. These derivatives are predominantly temperature-based but can include derivatives written against other weather phenomena such as precipitation, wind, frost and snowfall.
The weather derivative market in the U.S. has grown from around US$500 million in 1998 to over US$ 12 billion in 2003, and is still growing. Such growth has been attributed to the deregulation of energy markets and the significant effect that weather risk has on the volatility of revenue generated by a large number of companies. Significantly, these companies include electricity generators and retailers. Indeed, the weather derivative market in the U.S. was stimulated by the mild winters of 1997 and 1998, the consequence of the ‘El-Nino’ phenomenon. The associated potential for corporate earnings decline signalled the need for a hedge against abnormal weather behaviour.
