Example Weather derivates

Whether wind farm, solar plant, or hydroelectric power plant - they all depend on the right weather.

Renewable-energy power plants earn revenue mostly from the production of electricity. Fluctuations in weather conditions therefore have an immediate impact on their income and liquidity. For example, in the first few years of operation, wind farm operators must allow for the fact that the wind may blow less than average, resulting in a corresponding shortfall in revenue. In most cases, they do this by setting up reserves, but they could use derivatives instead, as these cushion losses, reduce the volatility of results, and so guarantee a stable cash flow.

Derivatives are financial instruments that are derived from or based on other financial assets or instruments. Options or swaps, for example, are well-known forms of derivative. Options may be based on shares, share indices, bonds, or exchange rates. Experts call this basis the "underlying instrument". Weather derivatives differ from conventional derivatives, however, in that they do not have any underlying instrument as their reference point: weather in itself is not tradable. The underlying instrument of weather derivatives is therefore based on data such as temperature or wind speed.

Consequently, the aim of weather derivatives is to hedge not price risks but the volume risks that can arise from changes in the demand for goods as a result of (extreme) weather variations. Weather derivatives are intended to hedge the financial risk that arises when demand, and with it sales potential, changes as a result of weather variations - be it plummeting ice-cream sales in a rainy summer or falling turnover due to prices slumping after an exceptionally good wheat harvest.

After many years' experience of working with specialist trading houses and writing business via funds, the Munich Re Group has decided to build up its own worldwide weather risks business and aim for a leading role in the market. The emphasis lies on individual solutions with a customised structure. These solutions are written either in the form of derivatives through the company's financial products subsidiary, Munich American Capital Markets (MACM), or in the form of an insurance policy contracted via the parent company, Munich Re, or its US subsidiary, Munich Re America.