A Weather Derivative is a financial product where two parties agree to exchange cash‐flows determined by reference to a Weather Index. The Weather Index is based on official weather data as published by National Meteorological Offices (for example the UK Met Office or NCDC in the US).
Weather Derivatives are designed to protect corporations against weather extremes which could happen every five to twenty years (or sometimes even more frequently).
For example a UK gas company may suffer from lower consumer demand as a result of warm winters in London. It could buy a weather derivative based on the average temperature as measured by the UK Met Office in London for the period November-March (the “Weather Index”). The company would pay a premium to benefit from the cover. In the case of a warm winter it would receive a pre-agreed payout that would be based on the value of the Weather Index.