What Is the Weather Future?

A weather future is a type of weather derivative in which the payouts depend on the total variation in the observed weather variable over a predetermined period—typically the recorded temperature.

Understanding Weather Futures

Businesses may safeguard themselves against losses resulting from unforeseen changes in weather patterns by purchasing weather futures. Companies may have property-casualty insurance policies that cover physical damage from relatively uncommon weather-related events, like windstorms or hail. Still, these policies do not cover economic losses if heavy rain prevents customers from coming in or if hot weather causes crops not to thrive.

Early in the 1990s, weather futures became famous for businesses to protect themselves against changes in indexes that track variations in the average daily temperature.

Essentially, the buyer of a weather future is obligated to pay the underlying weather index’s cash value. The most popular weather future contract covers the temperature at a future date recorded and expressed in heating degree days (HDD) or cooling degree days (CDD). The value of the relevant month’s HDD or CDD multiplied by $20 is usually the settlement price of the underlying weather index.

The number of degrees that the average daily temperature falls below 65 degrees Fahrenheit (18 degrees Celsius) is an HDD. On the other hand, a CDD is the degree to which the average daily temperature rises over 65 degrees Fahrenheit (18 degrees Celsius). The energy industry set a standard of 650 degrees to indicate the point in office buildings where the least amount of heating or cooling takes place. The payout is based on the total daily temperature variation over a predetermined period compared to the benchmark (650).

Since heating happens at lower temperatures, the buyer of an HDD weather futures contract will benefit if the cumulative temperature falls below the designated threshold. On the other hand, the buyer of a CDD weather futures contract will help if the cumulative temperature rises beyond the set amount since cooling happens at higher temperatures.

Farmers and energy companies are increasingly using weather futures to protect themselves from demand variations caused by changes in temperature. For instance, clients won’t need as much heat if October turns out to be warmer than anticipated. The energy business will lose money as a result of this. If the energy firm has, on the other hand, sold a weather future for October, it will be compensated for its losses by receiving the value of October’s HDD.

The weather is believed to impact 20% of the US economy directly, and virtually every industry sector—including construction, energy, travel and entertainment, agriculture, and power—depends on wind, temperature, and precipitation variations for its profitability. Former Commerce Secretary William Daley made the following suggestion in 1998 while testifying under oath before Congress: “Weather is not just an environmental issue; it is a major economic factor.” The weather affects at least $1 trillion of our economy.”

CME and Weather Futures

The Chicago Mercantile Exchange (CME) first offered exchange-traded weather futures and options on such futures in 1999. Weather derivatives sold over-the-counter (OTC) were previously customized, privately negotiated contracts between two parties.

Measuring either heating degree days (HDD) or cooling degree days (CDD), the CME weather futures and futures options are standardized contracts traded openly on the open market in an electronic auction environment. Prices are continuously negotiated and fully transparent.

CME-listed weather futures, which are cash-settled, use these indexes to represent the monthly and seasonal average temperatures for fifteen American and five European cities. The final monthly or seasonal index value determines the settlement pricing for these contracts, according to Earth Satellite (EarthSat) Corp., a multinational company that specializes in geographic information systems (GIS). Other businesses will determine values for non-CME-traded futures contracts.

Conclusion

• Businesses may safeguard themselves against losses resulting from unforeseen changes in weather patterns by purchasing weather futures.
• The total change in the measured weather variable over a predetermined period—typically the recorded temperature—is the basis for future weather payoffs.
• Early in the 1990s, weather futures became famous for businesses to protect themselves against changes in indexes that track variations in the average daily temperature.
• The most popular weather future contract covers the temperature at a future date that is recorded and expressed in HDD or CDD.