What Is Weather Future?

What Is Weather Future?

Let me explain what weather futures are directly to you: they're a type of weather derivative where the payoffs hinge on the total difference in a measured weather variable, most often the recorded temperature, across a specific period. If you're in a business affected by weather, this is something you should know about.

Key Takeaways

You need to understand that weather futures let businesses shield themselves from losses triggered by sudden weather changes. The payoffs come from the overall difference in the weather variable, usually temperature, over that fixed time. These futures started in the early 1990s to help companies hedge weather risks through indexes tracking average daily temperature shifts. The typical contract focuses on temperature in heating degree days (HDD) or cooling degree days (CDD) at a future point.

Understanding Weather Futures

As I see it, weather futures are essential for protecting your business against losses from unexpected weather shifts. Sure, you might have property-casualty insurance for rare events like windstorms or hail that cause physical damage, but those policies won't cover the economic hit if customers stay away due to heavy rain or if crops suffer in extreme heat.

These futures began in the early 1990s as a hedging method for firms, based on indexes that track changes in average daily temperatures.

In essence, when you buy a weather future, you're obligated to purchase the cash value of the underlying weather index. The most common ones deal with temperature, measured in HDD or CDD, settling at a future date. The settlement price usually equals the month's HDD or CDD value times $20.

Let me break down HDD and CDD for you: an HDD is the degrees a day's average temperature falls below 65°F (18°C), while a CDD is the degrees above that benchmark. The energy sector picked 65°F as the point where buildings need little heating or cooling. Your payout depends on the cumulative daily temperature differences from this benchmark over the period.

If you buy an HDD contract, you'll profit if temperatures cumulatively drop below the level, since heating demand rises in colder weather. For a CDD contract, it's the reverse—you gain if temperatures exceed the benchmark, boosting cooling needs.

I'm telling you, weather futures are gaining traction fast, especially for energy companies or agricultural producers hedging demand shifts from temperature changes. Take October: if it's warmer than expected, heating use drops, hurting energy firms. But if they've sold an October weather future, they get compensated via the HDD value for their losses.

Estimates show about 20% of the U.S. economy faces direct weather impacts, with profitability in sectors like agriculture, energy, travel, entertainment, and construction tied to temperature, wind, and precipitation fluctuations. Back in 1998, former commerce secretary William Daley testified to Congress that weather isn't just environmental—it's a major economic factor, with at least $1 trillion of the economy sensitive to it.

Weather Futures and CME

In 1999, the Chicago Mercantile Exchange (CME) launched exchange-traded weather futures and options on them for the first time. Before that, weather derivatives were over-the-counter deals, privately negotiated between parties.

CME's weather futures and options are standardized contracts traded publicly in an electronic auction setup, with ongoing price negotiations and full transparency. They're measured in HDD or CDD.

These CME contracts use indexes for monthly and seasonal average temperatures in 15 U.S. and five European cities, and they're cash-settled. Settlement prices come from the final monthly or seasonal index value calculated by Earth Satellite (EarthSat) Corp, a GIS specialist. Other firms handle values for non-CME contracts.