Weather Derivatives

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Hello, our readers!

A new week began with windy and rainy Monday morning.

By the way, do you guys know what made Starbucks to first succeed in Seattle where there’s huge rain? Some might believe wonderful taste of coffee is the main factor in its success. There is more crucial factor than the coffee flavor, though. It was coffee taste changed according to the weather that greatly contributed to the success of Starbucks. Likewise, there is no doubt that weather plays an important role in business world.

Along with this kind of successful stories―businesses using weather as their strategy― Korean market is also making a movement of introducing so-called ‘Weather Derivative’.

To help your understanding, here’s an easy example that will help you guys easily get the term.

weather derivative_diagramSuppose there are two people selling sunglasses and umbrellas, respectively. On rainy days, the person selling sunglasses might lose out. However, under the effect of weather derivative, he can reduce his loss since the person selling umbrellas would pay for his loss instead. This isn’t always bad for the umbrella-seller; he will be paid back from the sunglasses-seller later on sunny days when he will be suffering a loss.

So, to clarify the term, weather derivative refers to a financial instrument which is part of a risk management strategy to minimize risk related to adverse or unexpected weather conditions. A number of firms, especially in energy industry, are making use of this in order to get compensation in unfavorable weather condition based on several measurements. For example, heating degree day (HDD) is an index reflecting the demand for energy needed to heat a building, which is the most common type of weather derivative. Suppose a gas company finds out that 1 point drop in HDD results in the loss of one million dollar. Then, when HDD falls indicating abnormally warm winter, it will want to use weather derivative to make up for the loss.

The first exchange-traded weather future contracts was introduced by the Chicago Mercantile Exchange (CME) and has become hot commodities throughout the market and its sales volume has been increasing. Currently, various kinds of weather derivative are traded in CME for 25 cities in the United States, 9 cities in Europe, six in Canada and two in Japan.

weather derivative_diagram2In Korea, weather derivative has not been a familiar financial product for most people. However, Korean financial market is also preparing to accept this financial instrument as the financial authorities have stressed on its importance. Also, the importance of weather derivative will increase since more and more firms sensitive to climate variations demand a practical measurement to cope with this situation.

By Seunghye Shin (seunghye312@gmail.com)

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