According to Considine (n.d.

) the first transaction in the weather

derivatives market took place in 1997. Since then there has been a
formidable increase in the weather derivatives market with different
companies and individuals trying to hedge the losses due to unexpected
weather conditions.

The weather derivatives can be traded in the Forward, Futures or Options

market with the underlying asset traded as rainfall, humidity,
temperature, etc to hedge the monetary losses caused by unpredictable
weather. There is a constant increase in the Mean Global Temperature
and energy and water supplies prices. To check upon the Global
Temperature the governments are asking the consumers to use
Renewable Sources of Energy. Consider a hypothetical example of an
Australian citizen supporting “Go Green” campaign, has installed a rain
water harvesting and solar power system to meet the water and energy
needs respectively. The installation and operating costs are higher and
considering the uneven changes in the weather citizen is afraid to meet
the benefits of cutting down on the bills, which otherwise possible if the
optimal weather conditions are met. The maximum efficiency from the
two systems is generated if there is average rainfall and average sun
shine days for the given area.

The citizen can hedge the risk of systems being less efficient due to
unexpected weather conditions by entering into two forward contracts. A
weather derivative forward contract is an agreement between two counter
parties based on an underlying asset; weather, subjected to cash
settlement and pay off is based on prevailing weather conditions over the
given period (Brody, Syroka & Zervos 2002, p.1). Either party can take a
long or short position depending on the risk to hedge. The citizen can
enter into two cash settled forward contract with underlying asset as
sunny days and another one as the average rainfall in a year to hedge the
risk of decreased efficiency of solar power and rain harvesting systems
respectively. The contract includes duration of the contract, expiration
date, measuring entity for the underlying asset and the pricing of the
underlying asset (Jewson & Brix, n.d., p.4). Considering the sunny day’s
forward contract, the duration of the contract can be based on the
average number of sunny days in a year, measuring entity can be
metrological data on the same and a price can be attached to the average
number of sunny days. The same applies to the contract based on the
average rainfall .The citizen can take a short position in both the contracts
to hedge the decreasing number of sunny days and below average
rainfall. If there is less number of sunny days and below normal rainfall,
being in a short position the citizen on the expiration date will receive
cash equivalent to the range by which the sunny days and the rainfall was
below average and can make up for the losses due to unexpected weather
conditions.

Conclusively weather derivative is a financial instrument to hedge the

unexpected weather changes by treating it as a commodity.