Pricing Poseidon: Extreme Weather Uncertainty and Firm Return Dynamics

Abstract

We present a framework to identify market responses to uncertainty faced by firms regarding both the potential incidence of extreme weather events and subsequent economic impact. Stock options of firms with establishments in forecast and realized hurricane landfall regions exhibit large increases in implied volatility, reflecting significant incidence uncertainty and long-lasting impact uncertainty. Comparing ex ante expected volatility to ex post realized volatility by analyzing volatility risk premia changes shows that investors significantly underestimate extreme weather uncertainty. After Hurricane Sandy, this underreaction diminishes and, consistent with Merton (1987), these increases in idiosyncratic volatility are associated with positive expected stock returns.

Do banks fuel climate change?

“…Balvers et al (2017) show that firms subject to high temperature shocks have higher capital costs. There is evidence that extreme weather events are incorporated into stock and option market prices (Kruttli et al, 2019;Choi et al, 2020). 6 Transition risks arise from adjustments made towards developing a green economy and depend on the timing and speed of this process.…”

Stranded Fossil Fuel Reserves and Firm Value

“…Growing evidence indicates that climate risks may be priced in financial markets (Hong, Li, and Xu 2019;Daniel, Litterman, and Wagner 2019;Kumar, Xin, and Zhang 2019). At the firm level, Addoum, Ng, and Ortiz-Bobea (2019) show that extreme temperatures can adversely affect corporate earnings and Kruttli, Tran and Watugala (2020) show that extreme weather is reflected in stock and option market prices. Ginglinger and Moreau, (2019) provide evidence that suggests that after the Paris Agreement, greater climate risk leads to lower firm leverage with firms decreasing their demand for debt and lenders reducing their lending to firms with the greatest risk.…”

Returns and Hazard Mitigation: Evidence From Tropical Cyclones

“…This dissertation provides evidence that information about hazard mitigation infrastructure and the risk of exposure to tropical cyclones affects investors' trading behavior, i.e., they generate anomalies in returns. Firstly, the evidence that tropical cyclone risks generate anomalies in returns agrees with the growing literature that evaluates the effects of natural disaster strikes on companies' operations and stock prices short-term volatility (Dessaint & Matray, 2017, Kruttli et al, 2021. Secondly, understanding how effective hazard mitigation infrastructures are is fundamental in a world where climate changes are becoming the main worldwide concern.…”

“…My dissertation may contribute to the climate finance literature. Our contributions emphasize the tropical cyclones' capacity to generate uncertainty, as Kruttli et al, 2021 shows, to firms' operations and market prices. In the future, with a warmer world, this uncertainty could grow, making it even more important to investors, in general, to take into account this risk.…”

“…In that sense, other studies are more related to our goals. For example, Kruttli et al, 2021 shows that stock options of firms exposed to hurricane landfall exhibit large increases in implied volatility, which was not priced in terms of expected volatility, generating abnormal returns.…”