Q: What is a weather derivative?

A: It’s a financial instrument that seems like an insurance policy but is more like an option. Most weather derivatives are based on how much the temperature goes above or below 65 degrees. But weather derivatives can be based on anything measurable.

Q: An example of weather derivative

A: A ski area could pay a $250,000 premium to collect, say, $100,000 for every inch of snow this winter under the “strike” amount of 100 inches. This is like a “put” option. The ski area is out the premium whether or not snowfall is inadequate. Or, it could enter into a “swap” with another party, paying no premium and getting $100,000 for every inch under 100 and paying $100,000 for every inch over. Increased ticket sales in good winters would cover the cost.

There is also a “call” option where the ski area receives a premium of $250,000 and pays $100,000 for every inch over the strike 100 inches, again assuming higher revenue with heavy snowfall.

Q: Why would anyone assume financial risk by taking the other side?

A: Some are speculators. They believe they understand the probabilities of weather and are willing to wager just as a football fan might bet against a football team because he believes the quarterback is injured. But most parties take the other side of a weather derivative because they also are hedging. Cities, for example, might want to hedge against heavy snowfall because of the cost to clear the streets.

Q: What makes a weather derivative different than other derivatives?

A: All derivatives are used to hedge against bad news. Airlines use derivatives to protect against soaring jet fuel prices. Derivatives are commonly used to avoid fluctuations in interest rates or foreign currencies. What makes weather derivatives unique: They are not derived from anything with an underlying value.

Q: How big is the weather derivatives market?

A: Not very. The first wasn’t sold until 1997. It has grown to $12 billion and there are signs that some small companies are interested. Last June, the Rock Garden in London became the first restaurant to hedge against the cool weather that keeps customers from populating its outdoor tables. Aquila predicts $50 billion in weather derivative contracts by 2005, while the value of all derivatives traded worldwide is $100 trillion.

Q: Are there problems with weather derivatives?

A: Small fortunes can ride on weather instruments that are fallible. Gauges have gone unfixed for years. The National Weather Service sometimes moves instruments, and we’ve all seen rainstorms that hit on one side of the street but not the other. Unlike insurance, which spreads premiums and risks over time, derivatives are one-shot, risky deals that create big winners and losers in a hurry. It looks ripe for lawsuits, but traders say that hasn’t been the case. Also, financial markets need simplicity to trade in large blocks, but weather derivatives usually need to be customized to individual needs.

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