Pricing Poseidon: Extreme Weather Uncertainty and Firm Return Dynamics

80 Pages Posted: 11 Sep 2019 Last revised: 15 Mar 2021

See all articles by Mathias S. Kruttli

Mathias S. Kruttli

Board of Governors of the Federal Reserve System; University of Oxford - Oxford-Man Institute of Quantitative Finance

Brigitte Roth Tran

Federal Reserve Bank of San Francisco

Sumudu W. Watugala

Cornell University - SC Johnson College of Business

Multiple version iconThere are 3 versions of this paper

Date Written: March 14, 2021

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

Suggested Citation

Kruttli, Mathias S. and Roth Tran, Brigitte and Watugala, Sumudu W., Pricing Poseidon: Extreme Weather Uncertainty and Firm Return Dynamics (March 14, 2021). EBRD Working Paper No. 229, Available at SSRN: https://ssrn.com/abstract=3451323 or http://dx.doi.org/10.2139/ssrn.3451323

Mathias S. Kruttli (Contact Author)

Board of Governors of the Federal Reserve System ( email )

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HOME PAGE: http://www.federalreserve.gov/econresdata/mathias-s-kruttli.htm

University of Oxford - Oxford-Man Institute of Quantitative Finance ( email )

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HOME PAGE: http://sites.google.com/site/mathiaskruttli/home

Brigitte Roth Tran

Federal Reserve Bank of San Francisco ( email )

101 Market Street
San Francisco, CA 94105
United States

Sumudu W. Watugala

Cornell University - SC Johnson College of Business ( email )

Ithaca, NY 14850
United States

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