The Protective Shield of Weather Futures
Weather futures are a special category of financial instruments where payouts are determined by the aggregated variation in a specified weather variable—most commonly temperature—over a predefined time frame.
Key Takeaways
- Weather futures provide a financial mechanism for businesses to guard against losses emergent from unexpected shifts in weather conditions.
- The financial outcomes of weather futures are based on cumulative temperature differences over a specific period.
- These instruments emerged in the early 1990s, designed to help firms hedge weather-related risks by referencing indexes that track average daily temperature variations.
- Typical weather future contracts focus on temperature, quantifying it in Heating Degree Days (HDD) or Cooling Degree Days (CDD).
A Deep Dive into Weather Futures
Weather futures offer businesses a cushion against financial setbacks resulting from unanticipated changes in weather patterns. While some companies may have insurance coverage for damage due to severe weather incidents like hailstorms or hurricanes, many lack protection against economic disruptions such as reduced foot traffic due to heavy rain or crop failures caused by extreme heat.
Weather futures emerged in the 1990s, offering firms a tool to hedge their weather exposure by leveraging indexes that track changes in average daily temperatures.
In essence, a weather future obligates the purchaser to buy the cash value of an underlying weather index. The most typical contracts concern temperature measures, expressed in HDD (Heating Degree Days) or CDD (Cooling Degree Days), at a future date. The underlying weather index’s settlement price generally equates to the month’s HDD or CDD outcomes multiplied by $20.
Understanding HDD and CDD:
- An HDD quantifies the temperature fall below 65°F (18°C). For instance, an average daily temperature of 60°F results in 5 HDD, suggesting a need for heating.
- A CDD tallies degrees exceeding 65°F (18°C). For example, an average daily temperature of 70°F produces 5 CDD, indicating a need for cooling.
The 65°F mark, chosen by the energy industry, represents a threshold under which minimal heating or cooling is averaging needed in typical buildings. Payouts relate to the total daily temperature deviations from this benchmark during a specified period.
Investors in HDD weather futures profit if cumulative temperatures drop because heating is required at lower temperatures. Conversely, buyers of CDD weather futures benefit if cumulative temperatures rise because cooling becomes necessary at higher temperatures.
Weather Futures: Growing Popularity and Application
The utilization of weather futures has gained traction rapidly, emerging as a preferred method for energy firms and farming businesses to hedge against changes in demand triggered by temperature shifts. For instance, a warmer-than-expected October might lead to decreased heating usage. An energy company, hedging with a corresponding weather future, can offset lost revenue through the gains from a reduction in HDD.
It’s estimated that approximately 20% of the U.S. economy is directly weather-influenced, with nearly all industry sectors—agriculture, energy, travel, entertainment, construction— susceptible to temperature, wind, or precipitation variations. In 1998, William Daley, former commerce secretary, underscored: “Weather is not just an environmental issue; it’s a significant economic determinant.” He suggested that about $1 trillion of the economy’s productivity is weather-sensitive.
Harnessing the Power of Weather Futures: The Role of CME
In 1999, the Chicago Mercantile Exchange (CME) launched exchange-traded weather futures and options on those futures. Prior agreements were typically over-the-counter (OTC)—privately negotiated deals between distinct entities. The introduction of these instruments on the CME standardized the contracts, making them publicly traded with transparent pricing in an auction-like environment, fixing values in HDD or CDD.
The CME’s weather futures use specified indexes reflecting average monthly or seasonal temperatures from major cities in the U.S. and Europe. These contracts are cash-settled, with final settlement prices derived from monthly or seasonal index values computed by Earth Satellite (EarthSat) Corp., a global GIS-specialized firm. Various organizations offer similar indexes for non-CME traded weather futures contracts.
Related Terms: Weather Derivative, Futures Contract, Heating Degree Days, Cooling Degree Days, Hedge, Chicago Mercantile Exchange
