A weather derivative is a financial instrument that allows traders, companies, and individuals to manage the risk associated with weather events. Weather derivatives are typically traded over-the-counter (OTC) or through a broker or exchange. OTC contracts are bilateral in nature, whereas exchange-traded derivatives provide access to large amounts of liquidity. Weather derivatives resemble insurance, in the sense that it pays out to contract holders if a certain weather event occurs or if certain losses are incurred due to the weather. It is often used as a hedge by different industries, such as the energy market, travel and tourism, and especially agriculture.

Weather derivatives are most commonly used to hedge against extreme weather conditions and have the potential to protect companies and individuals from any losses they may suffer due to weather events. Companies may seek to offset their weather-dependent losses from both weather events that have already occurred and from anticipated future ones. For instance, a company in the energy market may choose to enter into a weather derivative contract to hedge against the risk of low temperatures in the winter causing higher energy demands, which may result in increased costs. Similarly, an agricultural business may use weather derivatives to hedge against drought, for which losses may be mitigated by the payments received from a weather derivatives contract.

Weather derivatives are based on weather indices, which measure both how extreme the weather is and how much damage the weather could cause a company. Weather derivatives contracts can often be customized to specific geographies, weather conditions and losses. They can have a range of maturities and payment frequencies and often focus on unusual weather events that are not compensated by traditional insurance policies.

Weather derivatives are a relatively new financial instrument and although they provide an effective way to manage weather-related risks, they also carry risks to the contracting parties because they don't have regulatory oversight or centralized exchanges. Furthermore, when entering into a contract it is important to be aware of the methodology used to determine the payout amounts, as this will vary based on the type of contract and the data used.

Overall, weather derivatives offer potential benefits to companies and individuals by providing protection against weather-related losses. However, it is important to understand the risks associated with weather derivatives before entering a contract. Companies must also be aware of the methodology used to determine the payout amounts. With a thorough understanding, weather derivatives can be an effective way to manage the risks and losses associated with the weather.