2021-23 | March 2021
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Pricing Poseidon: Extreme Weather Uncertainty and Firm Return Dynamics
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.
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Kruttli, Mathias S, Brigitte Roth Tran, and Sumudu W. Watugala. 2021. "Pricing Poseidon: Extreme Weather Uncertainty and Firm Return Dynamics," Federal Reserve Bank of San Francisco Working Paper 2021-23. Available at https://doi.org/10.24148/wp2021-23