Weather derivatives are the first financial tool available to risk managers to stabilise earnings volatility caused by the unpredictability of the weather. The market started during the summer of 1997 when two US power companies, realising that they had opposite weather exposure, entered into the first weather derivative swap contract for the upcoming winter season. Since then, the market in the US has grown rapidly to an estimated 2,500 deals with a value at risk (VaR) of around $5 billion.

They are increasingly becoming standard fare in the portfolios of utility companies with non-US based deals set to be of increasing importance over the coming year. Markets are also developing in Europe, East Asia, Australia and South America with predictions of the European market being worth $8 billion within the next two years.

 
 
  High Temperature Coverage
    Coverage of loss in crop yield due to high temperature. Crops like wheat and mustard are too prone to losses due to heat stress in month of February and March
    Example  
    A commodity trader Guddu Bhai who wants to hedge yield risk due to high temperature in month of March buys a HDD (High degree days) contract in which he receives a payment if temperature in March is higher than thresholds.
     
    Term sheet of product will be as following
   
Cover Period: 1st March to 31st March
   
Maximum temperature Threshold: 34 degree
   
Index (HDD): Sum of daily value of Maximum temperature over threshold ∑ Max (Tmax – Threshold, 0)
   
Strike: 30
   
Notional: Rs. 50 /degree
   
Sum Insured: Rs. 5,000
   
Premium: Rs. 500
 
  Unseasonal Rainfall Cover
    Coverage of loss in crop yield due to unseasonal rainfall. Crops like wheat and mustard are too prone to losses due to unseasonal rainfall during harvesting period
    Example 1  
    A commodity trader Mr. Parikh who wants to hedge yield risk due to unseasonal rainfall in month of April buys an ERI (Excess Rainfall Index) contract in which he receives a payment if total rainfall in April is higher than threshold.
     
    Term sheet of product will be as following
   
Cover Period: 1st April to 30th April
   
Index (ERI): Sum of rainfall over cover period
   
Strike: 150mm
   
Notional: Rs. 20 /mm
   
Sum Insured: Rs. 5,000
   
Premium: Rs. 500
 
    Example 2  
    A commodity trader Mr. Reddy who wants to hedge yield risk due to unseasonal rainfall in month of April buys an ERI (Excess Rainfall Index) contract in which he receives a payment if sum of 2 day rainfall in April is higher than threshold
     
    Term sheet of product will be as following
   
Cover Period: 1st April to 30th April
   
2 Day rainfall Threshold: 40 mm
   
Index (ERI): Sum of 2 day rainfall value above threshold ∑ Max (2 day rainfall – Threshold, 0)
   
Notional: Rs. 20 /mm
   
Sum Insured: Rs. 5,000
   
Premium: Rs. 500
 
       
  Each financial product sold by Weather Risk Ltd. can be described by a set of definitions that detail how the product works in terms of payout characteristics
  Location: To which city or cities will the weather be indexed? These locations are usually Indian meteorological department & state govt. managed weather stations.  
  Index: What is the actual index off of which the product will settle? This usually involves counting up daily measurements of a weather variable(s) over a period of time and organizing them in a way which represents the cash flows of the client.  
  Period: What is the calculation period for the index? The majority of weather derivatives are monthly or seasonal in nature but can be easily designed to be shorter or longer.  
  Notional: What is the payout rate per index unit beyond the strike? This amount is highly flexible and is usually linked to the underlying weather exposure being hedged.  
  Sum Insured: What is the maximum amount that can be paid out under the contract?