Weather Premium

The weather (risk) premium is a compensation for calendar-based weather uncertainty. Statistical analysis indicates whether future prices are on average too high, such that shorting the futures contract around the time of weather uncertainty will yield a statistically significant risk premium (a risk premium that exists even at er the occurrence of extreme weather losses, such that the risk premium is not subject to a "peso" problem).

In other words, long futures investors are willing to pay higher prices in order to hedge a disruption in their supply chain. Examples for the existence of a weather-related risk premium are the coffee risk premium in May/June (fears of cold weather that could damage the coffee crop) or natural gas in July (fears of hot weather, i.e., unusually high demand from the use of air conditioning).

Each of these short futures positions is very risky as there is no diversification in the cross section but only across time, that is, the coffee premium can be statistically reaped only at er many "Mays" and hence only makes sense in a diversified commodities program. In any case we talk about an exotic beta, as it is the compensation for passively taking on systematic risks, rather than an active strategy.

Weather Premium
Weather Premium
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