Weather derivatives are OTC contracts designed to allow hedgers to offset their exposure to weather-related risk. The units traded are cooling and heating degree days (CDDs and HDDs, respectively) which are meant to reflect the amount of energy required to cool or heat a building.
Q. Well this certainly sounds like an appropriate buzzword! Can I hedge out my exposure to all these hot days?
A. Yes, you can. And you can hedge out too many cold days this winter, along with too much frost in the fall or rain in the spring.
There are all sorts of new weather derivatives out there. And though they all used to be OTC, lots are now traded and cleared through exchanges.
Q. Pretty wild stuff. So how do they work exactly?
A. Well, given that its about 100 outside, lets look at the derivatives for hot weather. There is an index for “CDD”s— cooling degree days– that works off the average temperature for a day, measured from midnight to midnight at a specific weather station. The idea is to capture the number of days that require air conditioning during a specific period. In the simple form, then, you just buy a contract that pays $X dollars for every day that does. But you can have futures, options on futures, the whole menu.
Q So obviously very useful for power producers and industrial consumers… because there really aren’t any straight electricity derivatives, are there?
A. Not yet, anyway. So, yes, there are some real economic consequences at stake for all these contracts, which is how these things get regulatory approval.
Q. Right, because otherwise it looks a little bit like the government’s approved betting on whether or not it rains one day.
A. Exactly, that was actually my first reaction when I heard about these things a few years ago. You do need to show economic consequences to get CFTC clearance… but, of course, whether the Green Bay Packers win the Super Bowl also has economic consequences, so we’ll have to see where this whole trend goes…