Weather Derivatives: Answering The Devil's Advocate

Common objections to weather hedging products include:

• "We prefer a more conservative approach. Hedging with derivatives is too unorthodox for our company."
• "We use weather normalization to manage weather risk."
• "We tried it once, but the option didn't pay out."
• "We looked into using weather derivatives but found them too expensive."
• "The choice of available instruments isn't sufficient to cover our needs."
• "We simply don't have the expertise or capability in-house to effectively use weather derivatives."

Most if not all of these reasons would have been sufficient to dismiss the bottom-line benefits of weather derivatives a few years ago, when the market was in its infancy, but the current market has overcome the objections. How? Let's analyze each of these concerns.

We prefer a more conservative approach. Hedging with weather derivatives is too unorthodox for our company.

In fact, "derivative" is just another name for a future or option contract, trading concepts that have been around for a very long time. Futures and options are integral components to many markets, since they enhance market dynamics and provide a hedging mechanism to protect against setbacks.

To set the record straight; derivatives are simply a more general form of futures and options. Derivatives are not inherently bad, unsound, or unorthodox. Derivatives serve a vital role in many markets and have been widely used as effective hedging instruments for years.