Temperature Based

The most traded weather contracts are temperature based. They can generally be thought of as bets on the outcome of a temperature index, measured at various cities, and covering a specific time period.

Degree Days

Temperature based weather structures are mostly based on Degree Days. There are two major types: Heating Degree Days (HDD) and Cooling Degree Days (CDD). Degree days are calculated daily by applying a simple mathematical formula:

HDD = Max[0, Base Temp - (Tmax + Tmin)/2]

CDD = Max[(Tmax + Tmin)/2 - Base Temp, 0]

In the US, 65 degrees F is often used for the Base Temp. Outside of the US, Celsius is generally used, with a base of 18 or 18.5 degrees C.

In addition to the type of degree days being used, the index that a weather contract is based on must specify two additional things:

1) Location - where the temperature readings are to be taken from. The location can technically be anywhere, just as long as the integrity of the data can be assured. As such, the majority of temperature based weather derivatives structures have their locations set at major airports, where security is often high.

2) Time Period - each day, HDDs and CDDs are calculated from these location readings and then summed up over the course of the contract term. Weather derivatives are often traded with time periods covering from as little as one day, to a full winter or summer season. The winter heating season often covers the months of November through March, while the summer season covers the months May through September.

The payout of a weather derivative is calculated as the difference between the realized summation at the end of the period, less the price at which the contract was written, then usually multiplied by the dollar (or any other currency) amount per each degree day deviation. Maximum payout terms can and are often added to larger deals to limit the amount a counterparty must pay out or receive. It is this maximum payout "feature" of the weather market that was instrumental in attracting insurance companies to the market at inception. Smaller weather contracts, like those traded on the CME and other platforms, may not have maximum payout limits.

Example

To illustrate how a basic weather derivative contract may be structured and settled, consider the following example:

EnergyCo(EC) sells natural gas in the MidAtlantic US, specifically in Manhattan. EC is worried that if climate warming trends continue, that it may experience substantially lower revenues in the approaching November - March heating season.

EC decides to sell a HDD contract with the index location specified as Laguardia Airport, and covering the entire period of Nov-Mar. Based on its in-house analysis of Nov-Mar HDDs, it believes a good level for an average number of HDDs for this period is about 3600. However, EC decides that it can set the contract price (strike) at 3550 to entice market participants to take the other side. In doing so, EC is able to complete this trade at 3550 with a notional payout of $20,000 usd per degree day.

The winter heating season is indeed warmer than normal, with the total number of HDDs coming in at only 3120. Because of this deal, EC will be paid:

430(3550 - 3120) * 20,000 = $8.6 million.

If winter had indeed been cold, and the number of HDDs came in over the 3550 strike price, then EC would have lost on the deal. But EC would have also sold much more natural gas due to the colder temperatures during the season.

CAT

Another type of temperature based degree day-like index that is gaining popularity are Cumulative Average Temperature (CAT) structures. CAT weather derivatives are simpler than degree days since they do not use the MAX[0, ....] formula in HDDs and CDDs.

Instead, the CAT index is simply the summation of the daily average temperatures during the contract period. CAT structures generally are used for locations outside of the US, and use Celsius as the temperature scale.

Statistically, CAT structures can result in more normal distributions, and therefore more efficient pricing for weather derivative transactions.