Welcome to the Investors Trading Academy talking glossary of financial terms and events.
Our word of the day is “Weather Derivative”
A weather derivative is a futures contract or options on that futures contract — where
the underlying commodity is a weather index.
These derivatives work much the same way that interest-rate or stock index futures and options
do, by creating a tradable commodity out of something that is relatively intangible.
Analysts look at historical weather patterns — temperature, rainfall and other things
— develop averages, and quantify the risk that weather will deviate from the average.
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.
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.
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.
Insurance is still required to protect against major weather events, like tornadoes, hurricanes,
and floods.
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.