Pricing Poseidon: Extreme Weather Uncertainty and Firm Return Dynamics

Abstract

We present a framework to identify market responses to uncertainty faced by firms stemming from extreme weather events. Stock options of firms with establishments in a hurricane’s landfall region exhibit large, long-lasting implied volatility increases, reflecting significant uncertainty. Analyst calls show correspondingly persistent discussions of hurricane impacts on hit firms, which reveal business interruption and physical damages as dominant real channels. Comparing ex ante implied volatility to ex post realized volatility by analyzing volatility risk premia differences shows investors significantly underestimate extreme weather uncertainty until Hurricane Sandy. Despite constituting local, idiosyncratic volatility shocks, extreme weather events affect expected returns.

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

JEL Classification: G12, G14, Q54