Our word of the day is “Weather Derivative”

A weather derivative is a futures contract or options on that futures contract — where

the underlying commodity is a weather index. These derivatives work much the same way that

interest-rate or stock index futures and options do, by creating a tradable commodity out of

something that is relatively intangible. Analysts look at historical weather patterns — temperature,

rainfall and other things — develop averages, and quantify the risk that weather will deviate

from the average. Corporations use weather derivatives to hedge their risk that bad weather

will cause a financial loss. For a cereal company, bad weather might be a drought, which

would cause wheat prices to go up. For a home heating company, it could be warm days in

November, which could lower demand for home heating oil. And for an amusement park it

could be rain.

The cereal company and the amusement park might buy futures contracts with an underlying

weather index based on rainfall. The home heating company might want contracts based

on a temperature index.

Weather derivatives are different from insurance, because they’re linked to common weather

events, like dry seasons, or a warm autumn, that affect particular businesses. Insurance

is still required to protect against major weather events, like tornadoes, hurricanes,

and floods. You can buy weather derivatives as an individual, but you’ll want to consider

the trading costs carefully to ensure that your risk of loss is worth the expense.