The weather is a classic
example of a chaotic system
. It tends to behave predictably at very short or very long (attractor
) time intervals, in between which it appears random
weather is exceedingly difficult to predict due to its chaotical, butterfly-in-China
Options are extremely risky derivative securities; instead of betting on the underlying, you can place a bet on some contingent claim involving the underlying. For example, instead of actually buying a stock, you can place a bet that it will rise. You can place a bet on its volatility. You could bet that the value of the underlying will reach a certain point, without ever having gone below another certain point. You can bet on the number of tons of pork bellies sold in March. And you can bet on the weather.
For those of you who think that all this is purely for speculation, you're partially right. However, options were designed for hedging. If an option does not have a practical use for hedging risk, the SEC will probably ban it. Pure speculation is bad for the stability of financial markets. (Hedging is to buying yourself life insurance as speculation is to buying a life insurance policy on the motorcycle-riding guy down the street where you cash in when he dies)
Financial options on weather have surged in popularity for recent years, some sources quote the weather derivatives market at more tha $7 billion of notional outstanding value. Each contract is most likely, which means that it is custom made for the specific party and counterparty. The indices used are based on the specifications of those involved; a very common one is the average temperature over a period of time in a specific area. In December 2001, the LIFFE (International Financial Futures and Options Exchange) has begun trading futures settled against monthly and seasonal indicies based on daily average temperatures at London Heathrow, Paris Orly, and Berlin Tempelhof.
If you own a business, such as a chain of hotels in the midwest, the weather materially affects your cash flow. If the winter is unseasonably cold, then you spend more on natural gas. To offset this potential loss, you could buy an option based on the heat index in the midwest that would pay off based on the temperature. If the winter is unseasonably cold, the option pays off the losses incurred by extra heating. If it is not, you do not exercise the option, but you haven't spent the extra money on heating anyway.
Weather contracts, combined with credit derivatives, can also help hedge counterparty risk on forward delivery contracts in weather-sensitive product markets such as natural gas or electricity. Electricity and natural gas are some of the most volatile commodities on the market; weather derivatives can help eliminate some of the risk.
One main problem in treating weather as an underlying is that you must take into account the cyclical nature of the seasons which contributes to autocorrelation. Another issue is the treatment of weather derivatives under US Tax law; since they do not relate to a specified underlying asset, it's difficult to determine whether any profits are ordinary income, or capital gains.
Therefore, by trading weather, you too can eliminate weather-based risk!