Question

Define a weather related derivative security.

Describe the type of company that would most likely use one of these securities.

Select a company that would use a weather derivative and explain how it will benefit from it.

Answer 1

1. Weather is not just an environmental issue its also a big economic issue around the world. Industries like agriculture, entertainment, travel, energy etc are affected by it worldwide. Weather derivative tends to make it a tradeable commodity. Its a part of risk management strategy where an org tries to insulate itself from possible downsides caused due to weather anomalies. Modus Operandi :The seller of a weather derivative agrees to bear the risk of disasters in return for a premium. If no damages occur before the expiration of the contract, the seller will make a profit. In the event of unexpected or adverse weather, the buyer of the derivative claims the agreed amount.

It might seem as similar to weather insurance, indeed it is but still its quite different in its basic logic. Insurance covers low probablity catastrophic events like hurricane, cyclone whereas derivatives cover high probability lower intensity events like hotteror dryer summer than normal.

2. The type of companies which would use this type of derivative will be those whose business in some way can be affected by weather anomalies like Travel, shipping, agriculture, farmers assc, Oil & gas exploration etc.

3. A transnational courier company like FedEx can be a relevant example wherein its deliveries might get delayed or even damaged/lost due to bad weather in the country or above the oceans in that time it can hedge itself against the downside by agreeing with seller of derivative that in case of bad weather he'll get the claim. The claim which will cover its late delivery penalties.