Weather Asset Class

Weather derivatives themselves are an interesting class of derivatives. In general, a derivative is a financial contract that "derives" its value at any point in time during its existence from another asset (the "underlying"). But weather derivatives have no such underlying asset. There is no "asset" like a share of stock or a bond that can be purchased and held. Instead, weather derivatives get their valuation from a weather index that is calculated by taking meteorological readings at various sites.

Although this may appear strange at first, it lends weather derivatives an important aspect that is very different from other derivatives. Namely that if constructed well, the asset is impervious to market manipulation. At maturity, the weather derivatives contract always settles based on the natural weather event being measured.

To state this in another way: no matter who your counterparties are, or how many counterparties you have, the person setting the value of your trades is always Mother Nature.

Perceived Complexity

esoteric: adjective - very unusual and understood or liked by only a small number of people, especially those with special knowledge

Since their inception, weather derivatives have been thought of as strange and inherently complex. This actually could not be further from the truth.

Most of the complexity of weather derivatives is a result of the terminology and jargon market players use. As a financial instrument, its construction and pricing are simple compared to the myriad of instruments financial engineers have created and actively trade today.