Questions regarding weather Risk, breakeven exchange rate, - Essay Example

In fact, this sort of trading would be comparable to trading the varying values of stock indices, currencies, interest rates and agricultural commodities. However, the inception of the weather derivatives has made weather a tradeable commodity (Stephen Jewson, Anders Brix and Christine Zeihmann, 2005). Weather derivatives are financial instruments that can be applied by individuals or organizations as component of a risk management strategy to decrease the risk associated with adverse and unexpected weather conditions1.

It is different from the crop insurance that is generally used for high risk coverage. The weather derivatives are mainly used for low risk events. Until recently, insurance has been the main tool used by companies for protection against unexpected weather conditions. But insurance provides protection only against catastrophic damage. Insurance does nothing to protect against the reduced demand that businesses experience as a result of weather that is warmer or colder than expected. Farmers can use weather derivatives to hedge against poor harvests caused by drought or frost; theme parks may want to insure against rainy weekends during peak summer seasons.

Hence the CEO of ADLA must use weather derivatives. For example, a company might use a weather derivative to hedge against a frost ans heavy wind velocity (a low-risk, high-probability event). In this case, the company knows its revenues would be affected by that kind of weather. But the same company would most likely purchase an insurance policy for protection against damages caused by a flood or hurricane (high-risk, low-probability events).   In contrast to the various outlooks provided by government and independent forecasts, weather derivatives trading will give this company (ADLA) a quantifiable view of those outlooks and hence protects the interests of the company against adverse weather elements.

Over the counter trading weather derivatives are privately