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The fascinating world of weather derivatives

"It's hot, hot, hot, hot." That's how my 3 ½ year old son Cillian describes things that are, well, hot.

And outside it has been hot as hell, like an oven, pick your own personal favourite description, if you live in North Eastern or Mid Western North America.

My own personal favourite: "Finns have saunas. Canadians have weather."

I learned lots of fascinating information from Don Cyr, Associate Professor of Finance & Dean, Faculty of Business at Brock University when I spoke to him earlier today. Watch the interview.

The weather derivatives market dates back to 1996, when they were first designed by the infamous Enron Corporation. They caught on after 1998, an El Nino year that resulted in a warm North American winter. Cyr says energy companies suffered lost revenues and wanted a way to hedge against future losses. Weather derivatives started trading on the Chicago Mercantile Exchange one year later.

Energy companies buy weather derivatives as a hedge against risk. Unlike insurance contracts there is no moral hazard with a derivative contract and they don't necessitate an adjustor for a payout. It's a financial contract that either pays or doesn't. Also insurance contracts are for low probability/high cost events. Weather derivatives are for higher probability/low cost events. In practice, companies who want weather derivatives buy forward contracts or options. Eighty to ninety percent of weather derivatives are based on temperature variables. But there are also ones that pay out based on things like rainfall and snowfall amounts.

Weather derivatives are traded in a few different ways: on exchanges like the Chicago Mercantile, over the counter, and on online services such as those offered by Climate Corporation, formerly Weatherbill, which offers very specific contracts for specific weather events.

Cyr relayed an example of a hair salon in Atlanta, Georgia that once purchased weather derivatives that would pay out on weekends that had no rainfall. The contracts were structured this way because on rainy weekends the hair salon had lots of customers coming in. On dry weekends, business was slow. The revenue from the weather derivatives helped stabilize cash flow.

The market grew quickly from the late 90s until 2008, but then the global market for derivatives imploded. The market has bounced back a bit over the past year or so but it's still not the size it was pre-2008, Cyr says.

Interestingly even though there is a drought going on in many parts of Mid Western and North Eastern North America, Cyr says his research show that many agricultural companies aren't using weather derivatives as a hedge.

His explanation?

Rainfall is highly localized and even though purchasing a rainfall weather contract could work as a financial instrument, the farm in question may or may not get actual rain.


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