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.

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

JEL Classification: G12, G14, Q54