Weather derivative are financial instruments whose payoff is based on a specified weather event and is used to hedge the financial impact of weather fluctuations. Use of weather derivatives provides a means for businesses to protect themselves against adverse financial affects that are due to variations in climate. Weather derivatives are not the same as insurance, which is generally for low-probability events such as hurricanes and tornados. In contrast, derivatives cover high-probability events like dryer-than-expected summers. Weather derivatives also differ from insurance in a fundamental way in that insurance is based on payment for actual sustained losses, whereas weather derivatives generally payout based on contractual formula regardless of actual losses incurred.
Weather can adversely impact company revenues or increase costs. Use of weather derivatives can help mitigate the impact that adverse weather may have on profitability and reduce earnings volatility. In 2001 it was estimated that the weather derivatives market had grown to a $4.2 billion notional market value with approximately 4,000 contracts traded.
Transaction structures within weather derivatives include both swaps and options, as well as structured products and hybrids. The key underlying indices for use in weather derivatives are temperature levels (see HDD and CDD), precipitation (both rain & snow), wind, stream flow and various combinations of these. Thus far, most activity in the weather derivatives market has centered on managing the effects of seasonal temperature variations.
Weather Derivatives Market Participants: Key participants in the weather derivatives market include: energy marketers/utilities, insurance and reinsurance companies, financial institutions, over-the-counter (OTC) derivatives brokers, insurance brokers, and most recently hedge funds.
The end-users of weather derivatives include a wide range of companies from diverse industries. Primary end-user segments for weather derivatives include local distribution companies (LDC's) of natural gas, electric utilities, propane & heating oil distributors, agricultural and livestock companies, contruction firms, offshore production rig operators, beverage & food companies, travel & hospitality companies, retailers, municipalities, the transportation industry, and a range of manufacturing firms.
FAS 133 Accounting for Weather Derivatives: For U.S. accounting standards, Over-the-Counter (OTC) weather derivative transactions can generally get an exemption under derivatives & hedging disclosure rules of Financial Accounting Standard No. 133 (FAS 133) section 10 for non-exchange contracts settled on climatic variables, although specific structures and applications have to be assessed for each company environment.
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