Pricing Poseidon: Extreme Weather Uncertainty and Firm Return Dynamics

69 Pages Posted: 11 Sep 2019 Last revised: 28 Jan 2020

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

Board of Governors of the Federal Reserve System

Sumudu W. Watugala

Cornell University - Dyson School of Applied Economics and Management

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Date Written: January 28, 2020

Abstract

This paper isolates and estimates extreme weather uncertainty and its dynamics. Our framework identifies market responses to the uncertainty regarding both potential hurricane landfall and subsequent economic impact. Stock options of firms with establishments exposed to the landfall region exhibit large increases in implied volatility of up to 30 percent, reflecting impact unncertainty, which persists up to four months after landfall. Using hurricane forecasts, we find both landfall uncertainty and potential impact uncertainty are reflected in option prices before landfall. Our findings show the significant costs to hedging extreme weather uncertainty and have important implications for assessing the economic effects of extreme weather events.

Keywords: extreme weather, uncertainty, implied volatility, hurricanes, 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 (January 28, 2020). 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)

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

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Brigitte Roth Tran

Board of Governors of the Federal Reserve System ( email )

20th Street and Constitution Avenue NW
Washington, DC 20551
United States

Sumudu W. Watugala

Cornell University - Dyson School of Applied Economics and Management ( email )

Ithaca, NY
United States

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