What is a weather derivative?

A weather derivative or weather contract is a sophisticated over-the-counter financial product designed to accommodate a large variety of market participants who wish to gain financial exposure to the weather. With a weather derivative you can professionally protect your business against adverse weather conditions. A derivative can be customised to fit your unique risk profile and to suit your budget.

The contract is linked to weather conditions measured at a specific weather station or satellite grid, over a specific period. If the defined weather conditions are met, a pre-defined payout is triggered automatically. Unlike traditional insurance, no claim needs to be filed.

You specify the climatic events that you need cover against during a specific period, as well as the payout you want to receive should the events occur. A once-off premium is calculated based on the specifications of your desired derivative. The premium is the only required payment and thus you will not be liable to make any other payments besides the premium. Payouts are received promptly and automatically if your defined weather condition occurs. Should the period lapse without the specified event occurring, your derivative expires and you simply lose your premium.

Types of Weather Derivatives

We offer a selection of derivatives that can be customised to reflect your specific risk profile and subsequently offer you cover against unfavourable rainfall, temperature or NDVI levels.

Here is a summary of the derivative types including examples.

Certificate Aim Strategy Definition
Rain Day Certificate (Daily Index) Cover against excess rainfall Call option Client defines a Rain Day by specifying a daily rainfall Threshold in mm. Client receives a self-defined Payout, up to a Maximum, for every Rain Day above the Strike measured between Start and End dates.
Example:

XYZ Construction receives a tender to build an office block. The construction period is estimated to be 6 months. The main weather risk is a delay due to excessive rain.

Average fixed cost for each idle day is R 50’000, and rainfall in excess of 20mm within the specified period will put construction on hold. They establish that they can absorb 10 such rain days over the construction period.

XYZ then buys a Rain Day Certificate that pays out R 50’000, up to a maximum of R 500’000, for every Rain Day above the 10 day-strike. The derivative uses satellite data to determine the rainfall. The construction period passes, with a total of 15 rain days occurring over the period. XYZ receives a payout of R 50’000 x (15 – 10 rain days) = R 250’000.

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Certificate Aim Strategy Definition
Rain Season Certificate (Cumulative Index in mm) Cover against excess rainfall Call option Client receives a pre-defined Payout for each mm that the cumulative rainfall exceeds a pre-defined trigger (Strike) during the period from Start Date until End Date. Payout is capped at a Maximum.
Example:

A soybean farmer needs protection against flooding during March. He buys a Rain Season Certificate with a payout of R 10’000 per mm over a strike of 100mm and a maximum payout of R 1’000’000. The certificate period passes, with a total of 150mm rainfall for March as measured by the satellite. The farmer receives R 10’000 x (150 – 100) = R 500’000.

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Certificate Aim Strategy Definition
Dry Season Certificate (Cumulative Index in mm) Cover against deficit rainfall Put Option Client receives a pre-defined Payout for each mm that the cumulative rainfall falls below a pre-defined trigger (Strike) during the period from Start Date until End Date. Payout is capped at a Maximum.
Example:

A maize farmer needs protection against drought during January and February. He buys a Dry Season Certificate with a payout of R 20’000 per mm below a strike of 100mm and a maximum payout of R 1’000’000. The certificate period passes, with a total of 65mm rainfall for January and February as measured by the satellite. The farmer receives R 20’000 x (100 – 65) = R 700’000.

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Certificate Aim Strategy Definition
Heat Day Certificate (Daily Maximum Temperature Index) Cover against extreme heat Call option Client defines a Heat Day by specifying a daily maximum Threshold in °C. Client receives a self-defined Payout, up to a Maximum, for every Heat Day above the Strike measured between Start and End dates.
Example:

A soybean farmer needs protection against extreme heat during January and February. He buys a Heat Day Certificate with a payout of R 50’000 for every day that the maximum temperature exceeds 35°C, above a strike of 3 days. He specifies a maximum payout of R 1’000’000. The certificate period passes, with a total of 12 Heat Days occurring as measured by a nearby weather station. The farmer receives R 50’000 x (12-3) = R 450’000.

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Certificate Aim Strategy Definition
Frost Day Certificate (Daily Minimum Temperature Index) Cover against frost/extreme cold Call option Client defines a Frost Day by specifying a daily minimum Threshold in °C. Client receives a self-defined Payout, up to a Maximum, for every Frost Day above the Strike measured between Start and End dates.
Example:

XYZ Construction Ltd. needs protection against extreme cold during a construction period. They specify a Frost Day as a daily minimum below 5°C and buy a Frost Day Certificate with a payout of R 250’000 per Frost Day during the construction period. They also specify a Strike of 2 Frost Days and a maximum payout of R 2’000’000. The certificate period passes, with a total of 5 Frost Days occurring as measured by a nearby weather station. XYZ Construction Ltd. receives R 250’000 x (5-2) = R 750’000

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Certificate Aim Strategy Definition
CAT Certificate (Cumulative Daily Average Temperature Index) Cover against above or below average daily temperatures Call or Put Option Client receives a pre-defined Payout for each unit that the CAT Index is above (Call) or below (Put) the pre-defined trigger (Strike) for the period from Start Date until End Date. Payout is capped at a Maximum.
Example:

The Clothing Co. Ltd.’s key sales period is during winter and is concerned that above average temperatures expected for the coming winter will shrink their earnings. They’ve observed a 75% correlation between high sales levels and low temperature. They purchase a CAT Call Certificate for June – July with a payout of R 100’000 per CAT unit above a Strike of 850 CAT and a maximum payout of R 5’000’000.

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Certificate Aim Strategy Definition
HDD Certificate (Heating Degree Day Index) Cover against above or below average daily temperatures Call or Put Option Similar to a CAT Certificate, except the index measures days instead of cumulative units. Client defines a Heating Degree Day by specifying a daily average Threshold in °C. Client receives a self-defined Payout, up to a Maximum, for every HDD above (Call) or below (Put) the Strike measured between Start and End dates.
Example:

A maize farmer needs protection against frost damage during November. He buys a HDD Put Certificate with a payout of R 50’000 for every day that the Daily average temperature falls below 5°C. He specifies a Strike of 3 days and maximum payout of R 300’000. The certificate period passes, with a total of 7 HDD’s as measured by a nearby weather station. The farmer receives R 50’000 x (7-3) = R 200’000.

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Certificate Aim Strategy Definition
Low NDVI Season Certificate Cover against low NDVI levels Put Option Client receives a pre-defined Payout for each unit that the NDVI Index is below the pre-defined trigger (Strike) for the period from Start Date until End Date. Payout is capped at a Maximum.
Example:

A cattle farmer needs drought cover for his pastures from November to March. He buys an NDVI certificate that pays out R 100’000 per 0.1 unit below the Strike. He specifies the 25-year average NDVI level of his farm, 1.2, as the Strike for the Certificate. The month of March passes and the NDVI level, as determined by the satellite, is 4 units (4 decimal points) below the 25-year average for the period 1 November to 31 March. He receives a payout of R 100’000 x 4 = R 400’000.

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