A financial instrument (derivative) which is used to reduce or transfer the risk associated with unfavorable or unexpected weather conditions. The seller of that tool accepts to bear the risk by charging a premium (derivative price) to the buyer who seeks to guard off against bad outcomes of weather change. If the bad outcomes don’t occur, the seller gains (his profit being the premium), but if the weather turns bad, the buyer claims the money from the “losing” seller (his loss being the difference between the premium he received and the compensation he pays).

Weather derivatives are like insurance, though, unlike it, they cover events whose occurrence is “highly probable”, and that helps explain the relatively higher premiums on this type of derivatives.

The main types of weather derivatives are weather option, weather swap, and weather futures.