What it means
A futures contract is an agreement to settle at a future date based on a price or index agreed today. In a weather future, the underlying is not a barrel of oil or a bag of wheat but a number calculated from temperature records.
Two popular indices are heating degree days and cooling degree days, which add up how far the daily average temperature falls below or rises above a base level. Because weather cannot be delivered, these contracts are cash settled.
When the period ends, the exchange calculates the final index from official weather station data and one side pays the other the difference. Each point of the index is worth a fixed dollar amount, for example $20, so the payment is easy to calculate.
Weather futures trade on an exchange and are cleared through a clearing house, which stands between buyer and seller. That reduces the risk that the other side will not pay, and it means contracts are standard in size, dates and locations.
Buyers must post margin (a deposit held against possible losses) and gains and losses are settled daily. This differs from a weather derivative arranged privately between two parties.
A private contract can be tailored to the exact needs of a business, but it carries the credit risk of the other party and is harder to sell on. A future is less flexible, but it is transparent, easy to price and easy to exit before the end.
The main nuance is basis risk, the gap between the index and a company's real exposure. A utility serving a region far from the weather station used in the contract may find that its sales do not move in line with the index.
Anyone using weather futures should test how closely the index tracks their actual revenue before relying on it.
In practice
Real-world examples.
Example
A heating oil distributor in the northern states sells weather futures before winter. The season turns out to be warmer than usual, so customers buy less oil. The futures gain helps to make up the shortfall in sales.
Example
An electricity retailer in a hot region buys cooling degree day futures before summer, expecting that a cool summer would reduce air conditioning demand. If the summer is hot, it loses on the futures but earns more from power sales. The two effects balance each other.
Example
A hedge fund with no connection to energy trades weather futures because the contracts have little link to share prices. It takes a position based on long-range forecasts. Its trading provides liquidity for the businesses that need to hedge.
Formula
Calculation
Profit on a futures position = (Settlement index - Entry index) x Value per index point x Number of contracts, for a buyer
For a seller, the sign is reversed: (Entry index - Settlement index) x Value per index point x Number of contracts.
Suppose a gas supplier expects a warm winter, which would mean fewer heating degree days and weaker sales. It sells 50 contracts at an index level of 1,000, with each point worth $20. The winter is mild and the index settles at 900. The profit is (1,000 - 900) x 20 x 50 = 100 x 20 x 50 = $100,000, which offsets part of the lost gas sales.Case study
Seen in the real world.
Calloway Heating Supply is an illustrative, fictional distributor of heating fuel that earns most of its profit between November and March. The owner worried that a mild winter could erase a year of profit.
His finance manager suggested selling a small number of weather futures, sized so that a fall of 10% in heating degree days would be offset by a gain on the contracts. The company set aside cash for margin calls, which were a cost of holding the position.
In this illustrative story the winter was colder than usual, the contracts lost money, but fuel sales were strong. The owner learned that a hedge can lose money when the business does well, and that this is what protection looks like in practice.
Watch out
Common mistakes.
- Using weather futures to speculate without understanding the index, since the position can lose money quickly if the weather moves the wrong way.
- Forgetting margin, when daily gains and losses mean cash may need to be deposited before the contract ends.
- Assuming the contract will match the business exactly, when the weather station and the index may differ from local conditions.
Questions
People also ask.
How is a weather future different from a weather derivative?
A future is a standard contract traded on an exchange, while a derivative can be a private contract tailored to the buyer, so the term derivative covers both.
Do weather futures deliver anything?
No, they are cash settled, and the final payment is calculated from an index based on official weather data.
Who takes the other side of the trade?
Other hedgers with opposite exposure, banks, funds and traders who are willing to take weather risk for the chance of profit.
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