Reducing the variability of margins caused by climate events.
Weather derivatives are financial products that are closely linked to weather conditions. This product was created with the aim of reducing the variability of margins due to adverse weather events. Weather derivatives are customizable products: for example, if the temperature recorded in Milan in the winter period negatively affects revenues, through weather derivatives conditions can be managed more efficiently and risks reduced. Moreover, unlike other products, this solution allows to have a clear knowledge of economic exposure: the occurrence of certain weather conditions leads to a cash flow defined previously and limited to a maximum and a minimum. Weather derivatives, with a lower expenditure compared to traditional solutions, allow to protect oneself from risks that cannot be managed with other products.
The main features are ticksize, limits and strike:
- ticksize is the amount of money that is paid or received for each unitary movement of the chosen meteorological variable. To protect oneself against temperature variability, the ticksize will indicate the amount of money to be paid or received for the unitary temperature movement.
- high and low limits have the function of creating a "corridor" of payments, setting a maximum outlay and collection.
- strike is the value above which one pays or receives.
Weather derivatives can be stipulated on different weather underlyings, such as temperatures, rainfall, windiness and radiation, depending on which of these quantities affects the margins. The most commonly used underlyings are:
- Temperature [°C]:
- HDD - Heating Degree Day: It is calculated as the difference between average daily temperature and a threshold value, generally 18°C **. This index is used to manage temperature exposure in the winter period.
- CDD - Cooling Degree Day: it is the equivalent of HDD for the summer period.
- CAT – Cumulative Average Temperature: it is the sum of the temperatures recorded over a period
- Rain [mm]
- Wind [m/s – Km/h – knots]
- Radiation [W/m2]
The choice of the best index will be directed towards the one with the greatest correlation with cash flows.
* Average temperature means the average between minimum and maximum.
** It is assumed that 18°C is the temperature below which the heating systems are turned on and above which the cooling ones are turned on.