Pricing Poseidon: Extreme Weather Uncertainty and Firm Return Dynamics

Mathias S. Kruttli, Brigitte Roth Tran and Sumudu Watugala

No 2021-23, Working Paper Series from Federal Reserve Bank of San Francisco

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.

Keywords: extreme weather; uncertainty; implied volatility; expected returns; climate risks (search for similar items in EconPapers)
JEL-codes: G12 G14 Q54 (search for similar items in EconPapers)
Pages: 57
Date: 2021-03-01
New Economics Papers: this item is included in nep-env and nep-rmg
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Citations: View citations in EconPapers (10)

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Related works:
Working Paper: Pricing Poseidon: Extreme Weather Uncertainty and Firm Return Dynamics (2019)
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Persistent link: https://EconPapers.repec.org/RePEc:fip:fedfwp:93259

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DOI: 10.24148/wp2021-23

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