Hedging volume, not price
Most businesses can hedge the price of what they buy and sell. Very few can hedge how much of it they will need, and for a surprising number of industries that quantity is set by the weather.
A gas supplier's sales depend on how cold the winter is. A brewer's depend on how warm the summer is. A ski resort, a theme park, a construction firm, a wind farm — all have revenue that is a direct function of meteorology. Weather derivatives let them transfer that risk to someone willing to price it.
Degree days
The standard unit is the degree day. A heating degree day is one degree of average daily temperature below a reference point, usually 18°C. Sum them across a winter and you have an index of how cold it was, which correlates closely with heating demand.
A contract might pay a set amount per degree day above or below an agreed strike over a defined period at a defined weather station. Settlement is purely against the published data. Nobody assesses damage and nobody sends a loss adjuster.
Parametric, and why that matters
This is the key structural difference from insurance. A parametric contract pays on a measurement, not on a loss. That makes settlement fast, cheap and objective — but it means you can suffer badly and receive nothing because the measured index at the reference station did not cross the trigger.
That mismatch is called basis risk, and in weather contracts it is the central design problem. Choosing the right station, the right index and the right trigger is most of the work.
A growing use in developing agriculture
Parametric rainfall contracts are increasingly used to insure smallholder farmers in regions where conventional crop insurance is impossible to administer — no loss adjusters, no claims process, payment triggered automatically by a rainfall index. It is one of the more socially useful applications of derivative technology.
How you would actually trade it
A corporate treasury or specialist reinsurance conversation, not a trading screen. CME lists standardised temperature contracts for certain cities, but liquidity is thin and most real hedging happens bilaterally with reinsurers and specialist trading desks.
The practical work is quantifying your own exposure first: regress your revenue against historical weather data to find out what a degree actually costs you, then structure to that.
What goes wrong
- Basis risk is the dominant risk: the index moves but your business does not, or the reverse.
- Very low liquidity. These are held to expiry, not traded.
- Model risk. Pricing depends on historical weather distributions that climate change is actively shifting.
- Data risk. Settlement depends on a weather station continuing to report accurately.
This entry describes how a market works. It is not a recommendation, a price forecast, or advice about whether this belongs anywhere near your money. How entries are written.