Weather Futures: Definition, Mechanics, and Risk Management Strategies

Weather futures, a form of derivative, hinge on the aggregate difference in measured weather variables—typically recorded temperature—over a specific timeframe. Originating in the early 1990s, these contracts serve as risk management tools for businesses seeking to hedge against weather-related exposure by leveraging indexes that monitor changes in average daily temperatures.

Weather futures serve a practical purpose for businesses, filling gaps left by traditional insurance policies. While property-casualty insurance may cover physical damage from rare weather events, it often falls short in addressing economic losses arising from customer absence or crop failure due to adverse weather.

Incepted in the early 1990s, weather futures compel buyers to acquire the cash value of an underlying weather index. The most common contract involves recorded temperatures, measured in heating degree days (HDD) or cooling degree days (CDD), at a predetermined future date. Settlement prices are calculated as the value of the month’s HDD/CDD multiplied by $20.

HDD represents the degrees by which a day’s average temperature falls below 65°F (18°C), while CDD indicates the degrees by which it rises above 65°F (18°C). The benchmark of 650 was chosen by the energy sector to delineate the temperature where minimal heating or cooling occurs in office buildings. Payout is contingent on the cumulative difference in daily temperatures relative to the benchmark over a fixed period.

Buyers of HDD weather futures profit when temperatures are below the specified level, benefiting from increased heating needs. Conversely, buyers of CDD weather futures gain when temperatures surpass the specified level, capitalizing on heightened cooling demands.

The popularity of weather futures is escalating, particularly among energy and agricultural sectors. These contracts serve as a strategic tool to hedge against demand fluctuations resulting from temperature variations. For instance, a warmer-than-expected October might lead to reduced heat usage, causing losses for an energy company. However, if the company has sold a weather future for that month, it receives compensation based on October’s HDD, offsetting potential losses.

In 1999, the Chicago Mercantile Exchange (CME) revolutionized weather derivatives by introducing exchange-traded weather futures and options. This marked a shift from private over-the-counter (OTC) agreements to standardized contracts traded on the open market. These contracts, measured in HDD or CDD, offer continuous negotiation of prices, complete price transparency, and are publicly accessible.

CME-listed weather futures utilize indexes reflecting monthly and seasonal average temperatures for U.S. and European cities. Settlement prices are determined by Earth Satellite Corp, a global entity specializing in geographic information systems (GIS). The move towards standardized weather futures brought about market transparency, simplifying the trading process.

Approximately 20% of the American economy is directly impacted by weather. Industries such as agriculture, energy, travel, entertainment, and construction heavily depend on temperature, wind, and precipitation fluctuations for profitability.

The settlement price is calculated based on the final monthly or seasonal index value, determined by specialized firms like Earth Satellite Corp for CME-listed contracts. Non-CME traded futures contracts may have values determined by other firms.

No, weather futures primarily focus on economic losses resulting from customer absence or crop failures due to everyday weather variations. They do not cover physical damage caused by rare weather events, which is typically addressed by property-casualty insurance.