What is a Weather Derivative?

The weather derivative is an example of an investment strategy that involves consideration of elements such as wind speed, humidity, temperature, and other weather conditions that could place the investment at a high rate of risk. Like all forms of derivative investments, the weather derivative may involve bonds, equities, and other types of commodities. What is a little different is that the seller charges the buyer of a weather derivative a premium that serves as a safeguard against losses.

Many tend to think of a weather derivative as being associated only with high-risk investments that are connected in some manner with severe weather conditions. While it is certainly true that the performance of a weather derivative may be influenced by unexpected weather such as floods or hurricanes, the more common application has to do with temperature fluctuations. Essentially, many weather derivative investments are made based on projections of temperatures on a given day reaching a given range of high or low.

The weather derivative acts as a financial instrument that helps to reduce the amount of risk that may result in the event of adverse weather. With this type of investment, the seller continues to assume the risk associated with the investment. In order to cover this continuing liability, sellers normally charge a premium for a weather derivative. Should no unexpected weather conditions come to pass, then the seller will realize a profit. However, if adverse weather occurs and negatively impacts the derivative, buyer will profit from the investment.

A weather derivative is very different from insurance. The essential difference is that insurance is usually employed to cover circumstances that are possible but not very likely to occur frequently or for a long period of time. As a result, insurance is somewhat low risk in most cases. By contrast, a weather derivative is involved with accurately predicting circumstances with a high degree of probability within a given time period.