DEFINITION of Weather Future
A weather future is a type of weather derivative that obligates the buyer to purchase the cash value of the underlying weather index - measured in heating degree days (HDD) or cooling degree days (CDD) - at a future date. The settlement price of the underlying weather index is typically equal to the value of the relevant month's HDD/CDD multiplied by $20. Weather futures enable businesses to protect themselves against losses caused by unexpected shifts in weather conditions.
The popularity of weather futures is growing rapidly and becoming a more common method for energy companies or agricultural producers to hedge against a change in demand due to changes in temperature. For example, if the month of October is warmer than expected, customers will not use as much heat. This will cause a loss for the energy company. If, however, the energy company has sold a weather future for the month of October, the energy company will receive (because it's obliged to sell) the value of October's HDD, providing compensation for its losses.
BREAKING DOWN Weather Future
It has been estimated that roughly twenty percent of the American economy is prone to be affected directly by the weather, and that the profitability for virtually every industry sector — e.g. agriculture, energy, travel & entertainment, construction, to name just a few — depend on fluctuations in temperature, wind, and precipitation. During sworn testimony to Congress in 1998, former commerce secretary William Daley suggested, "Weather is not just an environmental issue, it is a major economic factor. At least $1 trillion of our economy is weather-sensitive."
While businesses may have property casualty insurance policies to cover physical damage caused by relatively rare weather related events, such as a windstorm or hail, insurance policies will not cover economic losses if customers aren't able to show up due to heavy rain, or if crops fail to thrive in hot weather. Weather derivatives sprung up in the early 1990s as a way for firms to hedge their weather exposure based on changes to indexes that measure changes in average daily temperatures.
In 1999, the Chicago Mercantile Exchange (CME) introduced exchange-traded weather futures as well as options on those futures for the first time. Previously, over-the-counter (OTC) weather derivatives are privately negotiated, individualized agreements made between two parties. But CME weather futures and options on futures are standardized contracts traded publicly on the open market in an electronic auction type of environment, with continuous negotiation of prices and complete price transparency, measured in heating degree days (HDD) or cooling degree days (CDD). A HDD is defined as the number of degrees that a day's average temperature is below 65o Fahrenheit (18o Celsius), which is the temperature below which buildings need to be heated - it therefore measures days when a building will need to use energy in order to be heated. Likewise, a CDD is the number of degrees that a day's average temperature is above 65o Fahrenheit (18o Celsius), which is the temperature above which buildings need to be cooled.
CME listed weather futures use such indexes to reflect monthly and seasonal average temperatures for 15 U.S. and five European cities, and are cash-settled futures. These contracts' settlement prices are determined by the final monthly or seasonal index value as calculated by the Earth Satellite (EarthSat) Corp, an global corporation specializing in geographic information systems (GIS). Other firms will determine values for non-CME traded futures contracts.