Business and Personal Finance Dictionary

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• DEGREE-DAY SWAPS
  
  A Swap (q.v.) that receives (pays) a floating payment proportional to the change in Degree-Days (q.v.) over the accrual period, and pays (receives) a fixed payment. Dealers of such swaps claim that they are good hedges of heating costs, because (1) a negative number of Degree-Days over the accrual period results in (2) a positive number of Heating Degree-Days, which leads to (3) a negative floating payoff, which is (4) a hedge for the resulting positive heating costs, because (5) a large number of Heating Degree-Days translates into both a large volume of energy and a high price for it. (Source: Victor Kremer, "Utility to Make First Use of Degree-Day Swaps, Derivatives Week, 5/5/97.) However, this argument has some problems. First, energy cost is a U- or V-shaped function of Degree-Days. Heating Degree-Days lead to heating costs, and Cooling Degree-Days lead to cooling costs. Second, nobody knows what that function is. Consequently, Degree-Days Swaps will have some Basis Risk (q.v.).
  
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