A weather derivative (originally introduced by US firm Enron Energy Corporation in 1997) that is used for hedging purposes, where two parties exchange two sets of cash flows at the end of a certain period based on the difference between the negotiated average degree days (the strike level), whether cooling (CDD) or heating (HDD)and the actual degree days (as recorded by a temperature index) in that period. In other words, degree day swap is a swap whereby one counterparty receives (pays) a floating payment proportional to the change in degree days over the accrual period, and pays (receives) a fixed payment.

The degree day measures essentially indicate the difference between the daily average temperature and a base temperature (usually 65° F) accrued for the entire year. So, if every day averages 2 degrees above the base temperature, the CDD value would be 730 (i.e. 365 x 2) and if every day were to average one degree below the base temperature, the HDD would be 365.

For example, an oil company that sells oil products, including heating oil, can tap swap markets to hedge against declining revenue if forecasts imply warmer-than-usual winters. Therefore, it can sell a degree day swap (specifically a heating degree day swap) at a strike level of 800 HDDs for the swap term (winter months), while settlement is made at USD20,000 per degree day. When the swap reaches maturity, the company pays USD 20,000 per every degree day less than 800 and receives USD 20,000 for every degree day higher than 800. Such a swap is usually used as a hedge of heating costs because it is often argued that a negative number of degree-days over the accrual period will result in a positive number of heating degree days, which is translated into a negative floating payoff. This can provide is a hedge for the resulting positive heating costs, because a large number of heating degree-days are reflected in a large volume of energy combined with a high energy price. However, energy cost is not forward- or backward sloping curve, but it is a U- or V-shaped function of degree days. Heating degree days will incur a firm heating costs, and likewise, cooling degree days result in cooling costs. Notwithstanding, the function is not known or defined for sure.