For when you're jonesin' for some complex/chaotic action but just can't seem to scratch that itch, superimpose one complex/chaotic system, markets, on top of another complex/chaotic system, weather, and away you go.
From Bloomberg, December 17:
As the world’s climate becomes increasingly volatile, businesses that depend on predictable weather are turning to financial products that compensate them when there’s a heat wave, a drought or an unusually persistent bout of rain.
Unlike better-known catastrophe bonds, which help to shield insurers against rare natural disasters, so-called weather derivatives offer protection from less severe but more common meteorological events. These contracts help companies to manage risks that may go barely noticed, such as a warmer winter or a rainier summer.
Here’s how weather derivatives work, and who is starting to use them:
What are weather derivatives?
Traditionally, companies involved in agriculture, hydropower and tourism tended to buy insurance against rarer types of disruptive weather event, such as cyclones. Those policies will only pay out if it can be proved that their finances had been materially affected.Buyers of weather derivatives get a payment when indexes tracking different aspects of the weather deviate from an agreed norm. A solar power plant operator could get paid when there’s an unusually high number of cloudy days. A farmer could get a payout if unseasonably hot weather wilts their crops.
Many businesses that purchase weather derivatives use them to stabilize revenue streams that would otherwise be more erratic due to fluctuating weather.
Where are weather derivatives bought and sold?
Some contracts focused on temperature are listed on the Chicago Mercantile Exchange (CME). Using so-called heating degree days (HDD) and cooling degree days (CDD) as parameters, they pay out when temperatures deviate from daily averages against an 18C baseline. Other indexes simply calculate the contract’s value by adding up the daily average temperatures through the contract period.The highest volume of weather derivative contracts is currently traded “over the counter” — that is, off the public markets. This is because buyers often prefer to work directly with sellers to customize the contracts so they include several payout triggers.
For example, a gas distribution company may want to hedge against various weather conditions that would lead a consumer to use less gas.
A power utility may want to hedge the risk of lost revenue if summer turns out to be cooler than normal. These variables can be plotted with precision using models that combine historical data with short and long-term weather predictions to create a product suited to the client.
How popular are weather derivatives?
Demand for weather derivatives is soaring, with average trading volumes for listed products jumping more than 260% in 2023, according to the CME Group. The number of listed weather derivative contracts that year was 48% higher than the previous May....
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