Developing and Tracking climate indices for the weather derivatives market

A critical aspect of developing weather derivative contracts and settling and assessing these financial instruments includes the identification of an appropriate index, the ability to clearly delinate how the index will be calculated, and a means to update and calculate the index on a near-real time basis. In this paper, we address each of these items by examining a number of climate indices that have been developed such as those for heating and cooling degree days, droughts and climate extremes. These examples provide a wide range of the difficulties encountered in developing and tracking an index including:

(1) its spatial representativeness, (2) the effects of instrument and station changes (3) the ability to develop a historical data base (4) the meaningfulness of the index to the parties, and (5) the problems related to real-time calculation of the indices versus retrospective quality control.

Based on a set of examples, suggestions are provided to overcome some of these difficulties.