Most of the industries in the world are directly or indirectly affected by weather changes. of late, due to the adversity of the green house effects and burning of fossil fuels, weather has turned out to be much more unpredictable. Weather risk can be defined as an uncertainty in the occurrence of normal weather conditions affecting, each and every business enterprise either favorably or adversely. Thus, weather derivatives come into play to hedge this weather risk. The growth that weather derivatives are able to accomplish is very high. Although the importance of weather is felt in different industries utility, gas and power, the energy and insurance sectors dominate the market.
Buy three calls, Oct Rain Mumbai Airport.1 Puzzled? Something similar will be the order placed by broking houses, if weather derivatives (rainfall) are introduced in India. It can be explained as an order placed to buy a rainfall future due in October, wherein, the rainfall is measured with reference to the statistics of rainfall measured at Mumbai airport. The contract will be paid on the basis of rainfall recorded in the month of October by the weather station at Mumbai Airport (most air stations measure rainfall).
The objective of this article is to look into what weather derivatives are, how they work and how they compare with other derivatives. Weather derivatives made a beginning, in the year 1998, and are currently experiencing rapid growth. The popularity of this derivative can be adduced to the fact that, most business houses are able to easily quantify/estimate the impact of a given weather risk on their business. Weather derivatives have come about because the traditional derivative or commodity contract may not be sufficient to meet in full, the risk management requirements of business firms. This is because all contracts introduced in an exchange do not report/attract volume and depth for an efficient price discovery. Unlike normal commodity futures, which are derived from spot and physical market, weather derivatives do not have either a spot or a physical market. However, there is abundant volume of weather data available at various places, to lend credibility to the contract build-up. Weather is also unique to a place and, therefore a multi-location business needs to manage a multi-location risk. Furthermore, it is important to note that weather will impact the volume in the physical market, which will impact the pricing of spot and futures market. In this background, weather derivative is so constructed that it will be able to address the risks more directly. It is, therefore, argued that addition of this to the available tools of risk management, makes the basket complete.
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