There are a number of businesses in the world whose output depends directly on certain meteorological conditions. Who can deny the fact that agriculture in India is directly dependent on the monsoon? Or for that matter, the generation of hydroelectric power across the globe is affected by rain in the catchment areas of the river.
So, what are weather derivatives? They are contracts between two parties that stipulate how payment will be executed between them depending on certain meteorological conditions during the contract period. Weather derivatives have no relation with the financial market. Unlike a financial derivative which has an underlying asset such as stock, price, index, a weather derivative is based on weather data collected over a long frame of time. Unlike normal commodity futures, which are derived from spot and physical markets, weather derivativation does not have either a spot or physical market. Business which is highly dependent on weather and is multilocational in nature uses weather derivatives as a risk management tool.
A weather derivative is not the same as weather insurance. To be entitled for a claim, a policy-holder must have incurred a loss and should be able to prove the same to the insurer. However, the derivative instrument is enforceable on the occurrence of an event whether or not the loss has been incurred. One might remember here that an insurance product is vague by definition of the events and are bilateral in nature whereas a derived instrument is quite concrete in definition and may be bilateral on exchange-traded. The only resemblance between the two perhaps is that both of them protect a downward risk. |
