Weather Derivative
Also known as: HDD/CDD swap, Temperature derivative, Weather hedge
A contract that settles on the temperature, not on any asset. Invented so an energy company could hedge a warm winter — the purest example of a derivative with no underlying you can own.
1 · SnapshotThe one idea to remember
2 · BeginnerWhat is it, really?
Most derivatives settle against a price. A weather derivative settles against a measurement — how cold a month was, how much rain fell, how much wind blew — at a named weather station.
The motivation is that many businesses are exposed to weather in a way no financial market covers. A gas utility sells less in a warm winter. An ice cream maker sells less in a cool summer. A ski resort has no season without snow. None of these losses are caused by a price move, so no price hedge fixes them.
The standard building block is degree days:
- Heating degree days (HDD): for each day, how far the average temperature fell below a reference (18 °C / 65 °F). Cold days accumulate HDDs.
- Cooling degree days (CDD): how far it rose above. Hot days accumulate CDDs.
A winter contract might pay €10,000 for every HDD below 1,200 across a season. If the winter is warm, HDDs are low, and the payment offsets the gas the utility did not sell.
a paymentonly if a condition is metnot a payment
Unlike insurance, nobody has to prove damage — and nobody has to have suffered any.
At the trade
- The buyer → The seller Structured either as an option with a premium or as a swap with none, on an index built from temperature, rain or wind.
Through the season
- Weather station → The seller From one named station. If that station's data is revised or its instruments change, the contract's fallback language decides what happens.
At the end of the period
- The seller → The buyer Paid on how far the index ended past the strike, multiplied by an agreed tick value.
Where it differs from insurance
- The buyer → The seller You can be paid without having lost anything, and you can lose without being paid — if your loss and the index at that station part company. That gap is called basis risk and it does not go away.
- Asset class
- Commodities (weather & energy)
- Instrument type
- Swap, option or future on an index
- Traded
- Mostly OTC; some CME-listed contracts
- Typical users
- Utilities, agriculture, retail, event organisers
Which risks decide the outcome
Not how risky this is, and not a rating — there is deliberately no total. It says which of five failure modes drives what happens here, in the same order on all 129 products so they can be compared. This publication's own reading; see the notice below.
- Marketdecides it
- Creditmatters
- Liquiditybarely applies
- Fundingmatters
- Operationaldecides it
What decides it here. It pays on a measurement at one named station, not on your loss. You can be paid having lost nothing and lose having been paid nothing.
3 · IntermediateHow it works in practice
The critical distinction: derivative, not insurance
| Feature | Weather derivative | Insurance |
|---|---|---|
| Trigger | An index reading | A proven loss |
| Proof required | None — the station reports | Claim, assessment, adjuster |
| Payout speed | Automatic at settlement | Weeks to months |
| Covers | Ordinary variation | Catastrophic events |
| Basis risk | Yes — the index is not your loss | Minimal by construction |
Parametric settlement is the feature and the flaw. Payment arrives without argument, and it arrives whether or not you actually lost money — and, more painfully, sometimes fails to arrive when you did.
Basis risk, concretely
- Geographic: your business is thirty kilometres from the reference station, and the weather differed.
- Index: temperature was normal, but a single unseasonal week destroyed the selling season.
- Business: revenue depends on weather plus competition, plus the economy — the correlation is real but never 1.
4 · AdvancedPricing & valuation
Pricing without a tradeable underlying
Weather is not storable, not tradeable and not arbitrageable. No-arbitrage pricing has nothing to work with — you cannot replicate a temperature. Pricing is therefore actuarial:
What the symbols mean
- Va value
- rthe interest rate, per year
- Tmaturity, in years
- Ean expected value
- Pa price, or a present value
- lambdaan intensity, usually of defaults per year
- The expectation is taken under the real-world measure from historical station data — typically 20–40 years, detrended for urban heat-island effects and climate drift.
- λ is an explicit risk-loading. There is no hedging argument to pin it down, so it is negotiated, and it is where the seller's margin lives.
- More sophisticated desks model daily temperature directly — mean-reverting with seasonal mean and seasonal volatility — and simulate the index. Better tails, same fundamental dependence on the historical record.
The detrending problem is now the main problem
Pricing assumes the historical distribution describes the future. A warming trend violates that assumption in a directional way: HDD contracts systematically overpay sellers and CDD contracts systematically underpay them if the trend is ignored. Every desk detrends; nobody agrees on the right window or method, and the disagreement is a larger source of price dispersion than the volatility estimate.
Who is on the other side
- Natural counterparties: a gas utility (hurt by warmth) and a power generator with heavy summer cooling load (hurt by cold) genuinely offset. These are the cleanest trades.
- Reinsurers and specialist funds take the residual for the risk premium — weather is close to genuinely uncorrelated with financial markets, the same appeal that drives the cat bond market and one of the few real diversifiers in diversification.
- Market size is modest by financial standards and concentrated in North American and European energy. The power and commodity swap markets dwarf it — but weather is the risk those markets cannot price.
The formulas above are standard textbook formulations, simplified for teaching. They explain the mechanism — they are not a valuation tool, and they will not reproduce a dealer’s price.
5 · Desk notesHow practitioners think about it
Now say it back
Close the page and give Weather Derivative in four sentences. It takes a minute and it is the only way to find out whether reading it was enough.
- Who wants what — two parties wanted opposite things badly enough to write it down.
- What the contract obliges, and when — not the payoff; the obligation.
- Where the money comes from — name the source, or you have described a hope.
- What makes it lose — the ordinary way, not the dramatic one.
Put Weather Derivative beside any other instrument →
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