How do heating degree days and cooling degree days work in weather derivatives?

Weather derivatives allow businesses to hedge revenue exposure to temperature fluctuations. Unlike insurance (which covers catastrophic events), weather derivatives cover non-catastrophic but financially significant temperature deviations.

Key Definitions

• Heating Degree Days (HDD): max(0, 65°F − Daily Avg Temp). Measures how cold a day is relative to the 65°F baseline. Higher HDD = colder weather = more heating demand.
• Cooling Degree Days (CDD): max(0, Daily Avg Temp − 65°F). Measures heat above baseline. Higher CDD = hotter weather = more cooling demand.

A contract typically covers a cumulative period (e.g., November through March for HDD, June through August for CDD).

Worked Example

Pinecrest Energy, a natural gas utility in the Midwest, earns more when winters are cold. To hedge against a warm winter:

1. Pinecrest buys an HDD put option for the Chicago O'Hare weather station, November–March.
2. Contract terms: Strike = 4,000 cumulative HDD, Tick size = $10,000 per HDD, Premium = $850,000.
3. If the actual cumulative HDD = 3,700 (warmer than normal):

• Payoff = (4,000 − 3,700) x $10,000 = $3,000,000
• Net gain = $3,000,000 − $850,000 = $2,150,000

1. If actual HDD = 4,200 (colder than normal), the option expires worthless. Pinecrest loses the $850,000 premium but earns extra revenue from higher gas sales.

Common Users:

• Utilities hedge volume risk (warm winters reduce heating demand)
• Agriculture hedges crop yield against drought or frost
• Ski resorts hedge against warm winters reducing snowfall
• Beverage companies hedge against cool summers reducing cold drink sales

Exam Tip: The FRM often tests whether you can compute cumulative HDD/CDD from a table of daily temperatures and then calculate the derivative payoff. Remember the 65°F baseline is standard for US contracts (18°C for international).

For deeper practice, try our FRM question bank on exotic derivatives.