Pricing Poseidon: Extreme Weather Uncertainty and Firm Return Dynamics

Abstract

We investigate the uncertainty dynamics surrounding extreme weather events through the lens of option and stock markets by identifying market responses to the uncertainty regarding both potential hurricane landfall and subsequent economic impact. Stock options on firms with establishments exposed to the landfall region exhibit increases in implied volatility of 5-10 percent, reflecting impact uncertainty. Using hurricane forecasts, we show that landfall uncertainty and potential impact uncertainty are reflected in prices before landfall. We find no evidence that markets incorporate better hurricane forecasts than those from NOAA. Improvements to hurricane forecasts could have economically significant effects in financial markets.

JEL Classification: G12, G14, Q54