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Hedging Financial Risk with Weather Derivatives

March 1, 2018 by Daniels Trading| Ag Marketing

One of the most unpredictable and influential factors facing economic output is the weather. Natural disasters, abnormal seasonal extremes, and even unexpected precipitation levels can have dramatic consequences on both industry and consumption.

According to the National Center for Environmental Information, the first nine months of 2017 produced 15 weather and climate disaster events in the U.S., each exceeding $1 billion in economic damages. Wildfires, hurricanes, regional freezes, and tornadoes are some of the leading causes of these losses.

So, is there any way producers can limit the impact inclement weather has on business? The answer is yes, through weather derivatives.

Guide to Smarter Ag Marketing

What Are Weather Derivatives?

The notion of weather derivatives first gained popularity in the mid 1990s with the deregulation of the U.S. energy industry. Needing a way to manage risks associated with climatic extremes, utility providers began to explore different ways of packaging and exchanging weather-related derivative products.

As pioneers in the field, energy trading companies began to conduct private over-the-counter (OTC) transactions using all sorts of temperature-based assets. Household names such as Enron and Koch Industries were heavily invested in these early OTC markets.

Today, weather derivatives are traded in a standardized format on the CME Globex Exchange. They come primarily in the form of futures and options contracts, specifically designed to account for abnormal fluctuations in temperature.

Temperature Indexes

The CME’s weather product suite consists of several unique temperature-based indexes. Through each of these contracts, temperature is able to be traded with respect to its deviation from a predefined norm at a given locale.

There are two types of U.S.-based temperature indexes available from the CME, each measuring the difference between a given day’s average temperature and a baseline of 65 degrees Fahrenheit:

  • Heating degree day (HDD): A HDD occurs when the average temperature for a given day is above the baseline at a specific locale.
  • Cooling degree day (CDD): A CDD occurs when the average temperature for a given day is below the baseline at a specific locale.

HDDs and CDDs may be traded on a monthly or seasonal basis as they relate to the climates of various cities located in the U.S. and Europe:

  • United States: Atlanta, Chicago, Cincinnati, New York, Dallas, Las Vegas, Minneapolis, Sacramento
  • Europe: London, Amsterdam

Hedging Financial Risk with Weather Derivatives

Using weather derivatives to hedge against unforeseen risk is preferred by many business interests over purchasing conventional forms of insurance. Agricultural, tourism and insurance industries, as well as utilities, are a few of the large-scale participants in these markets. In addition, many towns and municipalities implement weather derivatives to offset costs related to abnormal levels of snowfall, rainfall, cold or heat.

Many agricultural producers use temperature index futures as a way of insuring against drought and low-quality yields. Addressing risk through temperature index derivatives has several cost and flexibility advantages over traditional crop insurance.

For instance, if a Midwestern corn farmer wanted to mitigate the damage a drought could have on an upcoming crop, a position in monthly or seasonal Chicago and Cincinnati HDDs may be desirable. In the event that the crop is lost to drought, the gains made in the market will help to offset revenue lost from crop failure.

Putting It All Together

Trading weather-related contracts is different from engaging more popular sectors of the futures market. Volumes and liquidities are limited, so in many ways each participant’s trades are unique. Ultimately, the suitability of weather derivatives greatly depends upon the type of business you’re engaged in.

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Filed Under: Ag Marketing

About Daniels Trading

Daniels Trading is an independent futures brokerage firm located in the heart of Chicago’s financial district. Established by renowned commodity trader Andy Daniels in 1995, Daniels Trading is built on a culture of trust committed to the firm’s mission of Independence, Objectivity and Reliability.

Risk Disclosure

THIS MATERIAL IS CONVEYED AS A SOLICITATION FOR ENTERING INTO A DERIVATIVES TRANSACTION.

THIS MATERIAL HAS BEEN PREPARED BY A DANIELS TRADING BROKER WHO PROVIDES RESEARCH MARKET COMMENTARY AND TRADE RECOMMENDATIONS AS PART OF HIS OR HER SOLICITATION FOR ACCOUNTS AND SOLICITATION FOR TRADES; HOWEVER, DANIELS TRADING DOES NOT MAINTAIN A RESEARCH DEPARTMENT AS DEFINED IN CFTC RULE 1.71. DANIELS TRADING, ITS PRINCIPALS, BROKERS AND EMPLOYEES MAY TRADE IN DERIVATIVES FOR THEIR OWN ACCOUNTS OR FOR THE ACCOUNTS OF OTHERS. DUE TO VARIOUS FACTORS (SUCH AS RISK TOLERANCE, MARGIN REQUIREMENTS, TRADING OBJECTIVES, SHORT TERM VS. LONG TERM STRATEGIES, TECHNICAL VS. FUNDAMENTAL MARKET ANALYSIS, AND OTHER FACTORS) SUCH TRADING MAY RESULT IN THE INITIATION OR LIQUIDATION OF POSITIONS THAT ARE DIFFERENT FROM OR CONTRARY TO THE OPINIONS AND RECOMMENDATIONS CONTAINED THEREIN.

PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE PERFORMANCE. THE RISK OF LOSS IN TRADING FUTURES CONTRACTS OR COMMODITY OPTIONS CAN BE SUBSTANTIAL, AND THEREFORE INVESTORS SHOULD UNDERSTAND THE RISKS INVOLVED IN TAKING LEVERAGED POSITIONS AND MUST ASSUME RESPONSIBILITY FOR THE RISKS ASSOCIATED WITH SUCH INVESTMENTS AND FOR THEIR RESULTS.

TRADE RECOMMENDATIONS AND PROFIT/LOSS CALCULATIONS MAY NOT INCLUDE COMMISSIONS AND FEES. PLEASE CONSULT YOUR BROKER FOR DETAILS BASED ON YOUR TRADING ARRANGEMENT AND COMMISSION SETUP.

YOU SHOULD CAREFULLY CONSIDER WHETHER SUCH TRADING IS SUITABLE FOR YOU IN LIGHT OF YOUR CIRCUMSTANCES AND FINANCIAL RESOURCES. YOU SHOULD READ THE "RISK DISCLOSURE" WEBPAGE ACCESSED AT WWW.DANIELSTRADING.COM AT THE BOTTOM OF THE HOMEPAGE. DANIELS TRADING IS NOT AFFILIATED WITH NOR DOES IT ENDORSE ANY TRADING SYSTEM, NEWSLETTER OR OTHER SIMILAR SERVICE. DANIELS TRADING DOES NOT GUARANTEE OR VERIFY ANY PERFORMANCE CLAIMS MADE BY SUCH SYSTEMS OR SERVICE.

GLOBAL ASSET ADVISORS, LLC (“GAA”) (DBA: DANIELS TRADING, TOP THIRD AG MARKETING AND FUTURES ONLINE) IS AN INTRODUCING BROKER TO GAIN CAPITAL GROUP, LLC (GCG) A FUTURES COMMISSION MERCHANT AND RETAIL FOREIGN EXCHANGE DEALER. GAA AND GCG ARE WHOLLY OWNED SUBSIDIARIES OF STONEX GROUP INC. (NASDAQ:SNEX) THE ULTIMATE PARENT COMPANY.

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Risk Disclosure

THIS MATERIAL IS CONVEYED AS A SOLICITATION FOR ENTERING INTO A DERIVATIVES TRANSACTION.

THIS MATERIAL HAS BEEN PREPARED BY A DANIELS TRADING BROKER WHO PROVIDES RESEARCH MARKET COMMENTARY AND TRADE RECOMMENDATIONS AS PART OF HIS OR HER SOLICITATION FOR ACCOUNTS AND SOLICITATION FOR TRADES; HOWEVER, DANIELS TRADING DOES NOT MAINTAIN A RESEARCH DEPARTMENT AS DEFINED IN CFTC RULE 1.71. DANIELS TRADING, ITS PRINCIPALS, BROKERS AND EMPLOYEES MAY TRADE IN DERIVATIVES FOR THEIR OWN ACCOUNTS OR FOR THE ACCOUNTS OF OTHERS. DUE TO VARIOUS FACTORS (SUCH AS RISK TOLERANCE, MARGIN REQUIREMENTS, TRADING OBJECTIVES, SHORT TERM VS. LONG TERM STRATEGIES, TECHNICAL VS. FUNDAMENTAL MARKET ANALYSIS, AND OTHER FACTORS) SUCH TRADING MAY RESULT IN THE INITIATION OR LIQUIDATION OF POSITIONS THAT ARE DIFFERENT FROM OR CONTRARY TO THE OPINIONS AND RECOMMENDATIONS CONTAINED THEREIN.

PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE PERFORMANCE. THE RISK OF LOSS IN TRADING FUTURES CONTRACTS OR COMMODITY OPTIONS CAN BE SUBSTANTIAL, AND THEREFORE INVESTORS SHOULD UNDERSTAND THE RISKS INVOLVED IN TAKING LEVERAGED POSITIONS AND MUST ASSUME RESPONSIBILITY FOR THE RISKS ASSOCIATED WITH SUCH INVESTMENTS AND FOR THEIR RESULTS.

TRADE RECOMMENDATIONS AND PROFIT/LOSS CALCULATIONS MAY NOT INCLUDE COMMISSIONS AND FEES. PLEASE CONSULT YOUR BROKER FOR DETAILS BASED ON YOUR TRADING ARRANGEMENT AND COMMISSION SETUP.

YOU SHOULD CAREFULLY CONSIDER WHETHER SUCH TRADING IS SUITABLE FOR YOU IN LIGHT OF YOUR CIRCUMSTANCES AND FINANCIAL RESOURCES. YOU SHOULD READ THE "RISK DISCLOSURE" WEBPAGE ACCESSED AT WWW.DANIELSTRADING.COM AT THE BOTTOM OF THE HOMEPAGE. DANIELS TRADING IS NOT AFFILIATED WITH NOR DOES IT ENDORSE ANY TRADING SYSTEM, NEWSLETTER OR OTHER SIMILAR SERVICE. DANIELS TRADING DOES NOT GUARANTEE OR VERIFY ANY PERFORMANCE CLAIMS MADE BY SUCH SYSTEMS OR SERVICE.

GLOBAL ASSET ADVISORS, LLC (“GAA”) (DBA: DANIELS TRADING, TOP THIRD AG MARKETING AND FUTURES ONLINE) IS AN INTRODUCING BROKER TO GAIN CAPITAL GROUP, LLC (GCG) A FUTURES COMMISSION MERCHANT AND RETAIL FOREIGN EXCHANGE DEALER. GAA AND GCG ARE WHOLLY OWNED SUBSIDIARIES OF STONEX GROUP INC. (NASDAQ:SNEX) THE ULTIMATE PARENT COMPANY.

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