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What are weather derivatives and how are they used when dealing with hedge funds?
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Weather derivatives are financial instruments that can be used as a means of risk management hedge against losses due to adverse, unpredictable weather. Unlike other derivatives, the underlying asset (frost/rain/temperature/wind) is something that has no direct value with respect to the price of the weather derivative. The investor selling a weather derivative bears this risk for a premium and stands to profit if the weather remains relatively temperate. However, if the weather does turn bad, then the company that buys the derivative claims the agreed upon amount. Because the underlying asset of the weather derivative is non-tradeable, there is no standard model for valuing weather derivatives similar to the Black-Scholes formula for pricing European-style equity option and similar derivatives.

It is important to recognize that a weather derivative is not the same thing as insurance. Insurance is for high-risk, low-probability events such as tornados or hurricanes; derivatives, in contrast, cover low-risk, high probability events such as poor harvests caused by drought or frost, or sports events being rained out.

Products currently traded in the weather derivatives market include options, futures, forwards, and swaps. Many trades are OTC, but some are traded electronically on indexes like the Chicago Merchantile Exchange (CME). Temperature is the most commonly used underlying weather factor, with 65 degrees Fahrenheit being the baseline from which deviations are measured, but any other measurable weather-related event can be used as an underlying factor for a weather derivative.

The primary users of weather futures are energy companies in energy-related businesses (with agricultural companies coming in a distant second). One of the main difficulties in using weather derivatives as a cross-commodity hedge is in deciding the model risk inherent in determining how much of the risk can be effectively hedged using a weather contract. However, because of demand for alternative sources and strategies for revenue, weather derivatives are quickly gaining popularity within the hedge fund industry. It is estimated that nearly one third, or $3.8 trillion, of the U.S. economic activity is exposed to the weather.