Energy and weather derivatives are financial instruments that fluctuate in price because of underlying variables. When purchasing an energy or weather derivative, you are only purchasing the paper contract. Rarely in the case of energy derivatives does a person actually take delivery of the product. Energy derivatives as an instrument have a much longer track record than weather derivatives. Energy derivatives markets began in 1949; weather derivatives markets began in 1997. Because of the potential risk involved in each, you should only invest in energy and weather derivatives if you have a thorough understanding of the specific market.
Energy derivatives and weather derivatives are similar in that both offer protection against potential business risk. With energy derivatives, this risk is rising energy prices. Weather derivatives provide a type of insurance against adverse weather conditions. Most every business feels the economic effect of energy- and weather-related costs. However, you need to determine if either cost necessitates the investment in energy and weather investments. To assist this assessment, you should consider these issues before making a decision:
1. Understand the basics of energy and weather derivatives markets.
2. Analyze the potential problems and obstacles in energy and weather derivatives trading.
3. Decide if you want to hire energy or weather hedging consultants to assist your business in energy and weather derivatives pricing.
Action Steps
The best contacts and resources to help you get it done
Evaluate the workings of the weather and energy derivative market
The energy derivatives market offers a robust list of trading options such as swaps, futures and forwards. Each of these offers a different energy derivative strategy for your business. Understanding how each works is vital before making any investment. Conversely, weather derivatives offer fewer investment options with weather futures and options on those futures. Weather derivatives can effectively insure your business against high probability and lower cost weather-related risks if you understand the market.
I recommend: CME.com offers a history of weather derivatives. The
Weather Risk Management Association website has an introduction to weather derivatives. To understand the basics of energy derivatives and energy derivatives pricing, read
The Barnyard Basics Of Derivatives.
Evaluate the potential pitfalls of energy derivatives trading
Minimizing risk can sound like a good idea at first, but these derivatives are risky instruments. Therefore, learning as much as you can about this process is vital before investing any assets in the endeavor.
I recommend: Realize that derivatives are essentially a bet on the price movement of the underlying assets and that this venture can be detrimental to your business. Two historical examples are the
Indian derivative debacle and the
Orange County bankruptcy.
Contact energy hedging consultants
After you understand the basics and pitfalls of derivatives, it is a good idea to contact a consultant to discuss a weather and energy derivative strategy.
I recommend: Speak to a
weather or
energy hedging consultant to determine the best course of action. There are several consultants available on the Internet, but you can also contact a local derivative broker.
Tips & Tactics
Helpful advice for making the most of this Guide
- Because of the complexity of these financial instruments, it is not prudent to use derivatives of any kind without proper training or assistance. At the very least, you or someone in your business should take a financial derivatives course of study at the local business university.
The official source of Energy and Weather Derivatives is
the Energy and Weather Derivatives page at Business.com
Related Resources from Business.com
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