How Weather Derivatives Are Based On Standard Derivative Structures

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Weather derivatives are based on standard derivative structures, such as puts, calls, and swaps. Fundamental attributes of these structures are: the tick size, which is the payout amount per unit in the index beyond the strike; the strike, which is the value of the underlying index when the contract starts to pay-out; and the limit, which is the contract’s maximum financial payout.

v. Premium

The buyer of a weather option pays a premium to the seller that is typically between 10% and 20% of the notional amount of the contract. It can vary significantly depending on the risk profile of the contract. Usually there is not an upfront premium associated with swaps.

IV. What is the CME Group?

The Chicago Mercantile Exchange (“CME
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V. Who uses weather derivatives?

Within the larger category of exotic weather derivatives, there are a number of sub-categories that are utilized by companies who work in various markets. Unsurprisingly, the large companies who use weather derivatives are those whose businesses are widely affected by the weather on a day-to-day basis. Therefore, many weather derivative contracts are based on temperature, rainfall, and snowfall. Demand for sophisticated and flexible OTC products involving these three variables are growing far more quickly than standardized, exchange-traded contracts. And there are new ideas and experimental weather derivatives buzzing about the markets, including contracts based on sunshine and even wind patterns.
Although today energy companies are the biggest users of these trades, there is growing awareness and signs of potential growth in the trading of weather futures among agricultural firms, renewables, mining, retail, construction companies, restaurants, and even companies involved in tourism and travel, like hotels and airlines. The number of markets that could invest in and could benefit from weather derivatives is endless. Here are some examples of industries and companies that currently use weather derivatives, the type of weather they hedge on, and the risks they assume:

Figure 1
Risk Holder Risky Weather Type Risk Assumed
Energy Companies
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