How do weather derivatives work and who uses them?

Weather derivatives are financial instruments whose payoff depends on a measurable weather variable — most commonly temperature, but also rainfall, snowfall, or wind speed. They exist because many industries have revenues highly sensitive to weather.

Who uses weather derivatives?

Common structures:

1. Heating Degree Days (HDD) and Cooling Degree Days (CDD):

• HDD = max(65°F - Daily avg temp, 0) — measures cold
• CDD = max(Daily avg temp - 65°F, 0) — measures heat
• Accumulated over a month or season

2. Temperature put/call options:

• HDD call: pays if accumulated HDD exceeds the strike (colder than expected)
• CDD call: pays if accumulated CDD exceeds the strike (hotter than expected)

3. Swaps:

• Fixed-for-floating exchange based on actual weather vs. expected

Example: NorthStar Energy expects natural gas demand to drop if winter is mild. They buy an HDD put on November-March accumulated HDD:

• Location: Chicago O'Hare weather station
• Strike: 4,000 HDD (expected for a normal winter)
• Tick size: $10,000 per HDD
• Premium: $500,000

If the winter is mild and actual HDD = 3,600:

• Payoff = (4,000 - 3,600) × $10,000 = $4,000,000
• Net gain = $4,000,000 - $500,000 = $3,500,000
• This offsets the revenue loss from lower gas demand

If the winter is cold (HDD = 4,500), the put expires worthless. But NorthStar's revenue is higher from increased demand, so the premium is the cost of insurance.

Key differences from traditional derivatives:

1. No physical delivery possible — you can't deliver or store weather
2. Basis risk — the weather station location may not match the actual exposure location
3. Settlement is objective — based on official weather station data (no manipulation risk)
4. Not directly traded on exchanges (mostly OTC, though CME lists some)

Exam tip: FRM tests the structure of weather derivatives (HDD/CDD), who the natural hedgers are, and the distinction between weather derivatives (short-term exposure) and catastrophe bonds (extreme event risk).

Explore exotic derivatives on AcadiFi's FRM course.