Pricing Poseidon: Extreme Weather Uncertainty and Firm Return Dynamics

Abstract

We empirically analyze firm-level uncertainty generated from extreme weather events, guided by a theoretical framework. Stock options of firms with establishments in a hurricane’s (forecast) landfall region exhibit large implied volatility increases, reflecting significant uncertainty (before) after impact. Comparing implied volatility to subsequent realized volatility shows that investors underreact. This underreaction diminishes for hurricanes after Sandy, a salient event that struck the U.S. financial center. Despite constituting idiosyncratic shocks, hurricanes affect hit firms’ expected stock returns. Textual analysis of calls between firm management, analysts, and investors reveals that discussions about hurricane impacts spike during the long-lasting high-uncertainty period after landfall.

Keywords: extreme weather, uncertainty, implied volatility, expected returns, climate risks

JEL Classification: G12, G14, Q54