Abstract
Weather is an uncertain force of the nature affecting many businesses. Insurance has been used as a traditional method to cover such vagaries of weather. The latest approach to transfer and hedge these risks is known as weather derivatives working in the capital market. But unlike the insurance sector these derivatives are not based on prices. They have volume or quantity as base and are not perfectly correlated with the losses experienced. Weather derivatives are developed to manage weather risks and form one of the fastest growing derivative markets. This is a convergence of the insurance and the financial market. This article aims to provide an overview of weather risks, weather derivatives, weather derivative market and optimal weather hedging with the consideration of basis risk (The risk created by the by the fact that the from the financial derivative is a function of weather pre-specified geographical which may not be identical to the location of the firm) and credit risks (The risk that the counterparty to the derivative contract may not perform).
Introduction
Business is exposed to many type of risk. Some are the predictable and controllable but some are not. The real problem is one of tackling the uncontrollable risks, and the most unpredictable risk factor till date is weather. All the business is exposed to this risk. It is reported that all businesses face up to 70 percent weather risk of some sort. The major businesses exposed to weather risk are construction, energy (power), entertainment, manufacturing, retail, travel, tourism, agriculture and many others. But the effect of weather on the agriculture and power sector is substantial and there is an indirect effect on the retail business. For instance, ...