Temperature, Aggregate Risk, and Expected Returns

53 Pages Posted: 4 Nov 2011

See all articles by Ravi Bansal

Ravi Bansal

Duke University and NBER

Juan Marcelo Ochoa

affiliation not provided to SSRN

Date Written: November 2011

Abstract

In this paper we show that temperature is an aggregate risk factor that adversely affects economic growth. Our argument is based on evidence from global capital markets which shows that the covariance between country equity returns and temperature (i.e., temperature betas) contains sharp information about the cross-country risk premium; countries closer to the Equator carry a positive temperature risk premium which decreases as one moves farther away from the Equator. The differences in temperature betas mirror exposures to aggregate growth rate risk, which we show is negatively impacted by temperature shocks. That is, portfolios with larger exposure to risk from aggregate growth also have larger temperature betas; hence, a larger risk premium. We further show that increases in global temperature have a negative impact on economic growth in countries closer to the Equator, while its impact is negligible in countries at high latitudes. Consistent with this evidence, we show that there is a parallel between a country's distance to the Equator and the economy's dependence on climate sensitive sectors; in countries closer to the Equator industries with a high exposure to temperature are more prevalent. We provide a Long-Run Risks based model that quantitatively accounts for cross-sectional differences in temperature betas, its link to expected returns, and the connection between aggregate growth and temperature risks.

Suggested Citation

Bansal, Ravi and Ochoa, Juan Marcelo, Temperature, Aggregate Risk, and Expected Returns (November 2011). NBER Working Paper No. w17575, Available at SSRN: https://ssrn.com/abstract=1954501

Ravi Bansal (Contact Author)

Duke University and NBER ( email )

Box 90120
Durham, NC 27708-0120
United States
919-660-7758 (Phone)
919-660-8038 (Fax)

Juan Marcelo Ochoa

affiliation not provided to SSRN ( email )

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