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.
- 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
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.
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:
- 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.