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Weather derivatives are a type of investment strategy that considers weather conditions such as temperature and humidity. The seller charges the buyer a premium to protect against loss, and the investment is based on projections of temperature fluctuations. It is different from insurance as it accurately predicts circumstances with a high degree of probability.
The weather derivative is an example of an investment strategy that involves consideration of elements such as wind speed, humidity, temperature, and other weather conditions that could place the investment at a high rate of risk. Like all forms of derivative investments, the weather derivative can involve bonds, stocks, and other types of products. What is slightly different is that the seller charges the buyer of a weather derivative a premium that serves as protection against loss.
Many tend to think of a weather derivative as being associated only with high-risk investments that are related in some way to severe weather conditions. While it is true that the performance of a weather derivative can be influenced by unexpected weather, such as floods or hurricanes, the most common application has to do with temperature fluctuations. Essentially, many weather-derived investments are made based on projections of temperatures on any given day reaching a given high or low range.
The weather derivative acts as a financial instrument that helps reduce the amount of risk that adverse weather can give rise to. With this type of investment, the seller continues to bear the risk associated with the investment. To cover this ongoing liability, sellers typically charge a premium for a weather derivative. Barring unexpected weather conditions, the seller will make a profit. However, if adverse weather occurs and adversely affects the derivative, the buyer will benefit from the investment.
A weather derivative is very different from insurance. The essential difference is that insurance is generally used to cover circumstances that are possible but unlikely to occur frequently or for a long period of time. As a result, the insurance is low risk in most cases. By contrast, a weather derivative is involved in accurately predicting circumstances with a high degree of probability within a given period of time.
Smart Asset.
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