An Introduction to Weather Futures

Weather futures are a type of investment that can be purchased in order to speculate on weather conditions. This type of investment is relatively new compared to stocks or bonds and it is growing every year. In 1997, the first weather future was traded. Before that, there was growing concern by many businesses that the weather could negatively affect their profit. Some estimates say that over $1 trillion of the economy is directly linked to the weather. This represents a large amount of risk for business owners. Before weather futures were invented, business owners simply had to deal with this risk as best as they could.

How They Are Traded

Weather futures can be set up as a contract between two parties. They can also be traded on exchanges much like stocks or ETF's. You can open up an account with a brokerage and buy and sell these futures contracts. This provides great liquidity for this type of investment and allows many different investors to get involved.

The primary purpose of these futures contracts is to help companies mitigate risk. Many types of businesses can be negatively affected by strange weather occurrences. The most common example of this is with energy companies. For example, if it is much warmer than average in the winter, energy companies will not generate as much profit. Businesses that rely on tourism also rely on good weather during the summer to get tourists to their businesses. If the weather does not cooperate, these businesses could lose vast sums of money. By purchasing a weather futures contract, these businesses can mitigate risk and still get profit.

Investors and Insurance

The majority of investors in this market are businesses and energy companies are the biggest participant in the market. However, there are many other businesses that choose to get involved in this market as well. All of them are affected by the weather in some way.

Weather insurance is purchased by companies in order to provide protection against short-term risks. Weather futures are designed to mitigate against prolonged weather conditions such as a winter month that has an average temperature of 10° higher than normal. Weather insurance is a type of coverage that is designed to cover catastrophes such as a flood, a tornado, or a hurricane. Most of the time, businesses that are involved in the weather futures market, also purchase weather insurance policies. 

How They Work

The idea behind weather futures is that you can quantify the weather, and then standardize it. With the current system, investors basically bet on how far away the temperature will be from 65°F. If the temperature is over this amount, they refer to it as a cooling degree day because homeowners will use air conditioning. If the temperature is below the indicated level, it is referred to as a heating degree day, because they will have to use heat.

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