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Weather DerivativesWeather derivatives are financial instruments that can be used by organisations or individuals as part of a risk management strategy to reduce risk associated with adverse or unexpected weather conditions. The difference to other derivatives is that the underlying asset (rain/temperature/snow) has no direct value to price the weather derivative. Farmers can use weather derivatives to hedge against poor harvests caused by drought or frost, theme parks may want to insure against rainy weekends during peak summer seasons, and power companies may use HDD (Heating Degree Days) contracts to smooth earnings. Heating degree days are one of the most common types of weather derivative. Typical terms for an HDD contract would be like: for the November to March period, for each day where the temperature falls below 18 degrees Celsius keep a cumulative count. Depending upon whether the option is a PUT or a CALL, pay out a set amount per heating degree day that the actual count differs from the strike.
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