Introduction

This book is about the valuation of a certain class of financial contracts known as weather derivatives. The purpose of weather derivatives is to allow businesses and other organisations to insure themselves against fluctuations in the weather. For example, they allow natural gas companies to avoid the negative impact of a mild winter when no one turns on the heating, they allow construction companies to avoid the losses due to a period of rain when construction workers cannot work outside and they allow ski resorts to make up for the money they lose when there is no snow.

The weather derivatives market, in which contracts that provide this kind of insurance are traded, first appeared in the US energy industry in 1996 and 1997. Companies accustomed to trading contracts based on electricity and gas prices in order to hedge their electricity and gas price risk realised they could trade contracts based on the weather and hedge their weather risk in the same way. The market grew rapidly and soon expanded to other industries and to Europe and Japan. Volatility in the financial markets has meant that not all of the original participants are still trading, but the weather derivatives market has steadily grown and there are now a number of energy companies, insurance companies, reinsurance companies, banks and hedge funds that have groups dedicated purely to the business of buying and selling weather derivatives.