Gus Kmetz, Mathias Kruttli, Brigitte Roth Tran, Sumudu Watugala, and Alan Yan
Extreme weather can have negative, minimal, or even positive effects on business performance—creating significant uncertainty about outcomes for those businesses. Financial markets show heightened uncertainty among investors for companies that have been hit by hurricanes. This uncertainty persists for several months after a hurricane’s landfall, as reflected by continued discussion of hurricanes in analyst calls. Comparing expected volatility to actual volatility shows that markets have underreacted to the uncertainty caused by hurricanes. After Hurricane Sandy, a particularly salient hurricane for investors, this market underreaction appears to have diminished.
Extreme weather events like hurricanes have caused hundreds of billions of dollars in damages in recent years, affecting not only households and public infrastructure but also businesses (Smith 2022). The unpredictable impacts of extreme weather events on a company’s capital, operations, and business environment can create significant uncertainty for firms and investors. Mispricing of such events in asset markets could lead to sudden sharp price corrections. Yet in the emerging research about potential financial effects from climate risk, little is known about the uncertainty that extreme weather events generate for firms or how financial markets reflect such uncertainty in prices.
In this Economic Letter, based on research by Kruttli, Roth Tran, and Watugala (2023), we use firm-level exposures to hurricanes from 1996 to 2019 to understand how extreme weather events affect firm performance in financial markets as measured by option and stock prices. We show that asset prices in financial markets adjust to account for significant uncertainty for companies that have been hit by hurricanes. We then show that investors historically underreacted to the volatility arising from the uncertain impacts of a hurricane and did not efficiently update their volatility expectations based on the information available in real time. We find that investor underreaction to hurricanes diminished after Hurricane Sandy, suggesting that the informational efficiency of markets improved after this particularly salient extreme weather event that many investors experienced personally.
Hurricanes increase uncertainty for affected firms
Extreme weather events can affect businesses in a variety of ways. In addition to damaging physical assets, such events can disrupt normal business activities, imposing costs like lost sales, evacuations, or shutting down and restarting of plant operations. Extreme weather events can also upset supply chains or slow demand for products. However, for some companies, such events can present opportunities, such as higher demand for products like power generators or construction supplies. Also, some firms may be able to mitigate the negative impacts of extreme weather events through insurance or adaptation. For example, companies could relocate to less vulnerable areas. However, because adaptation and insurance are costly and not always available, incomplete insurance or adaptation can leave some firms facing significant losses after extreme weather events. This can lead to investor uncertainty about how firms will fare after being hit by such events, which can be reflected in market valuations.
Considering the wide range of potential effects to businesses from extreme weather, markets may not reflect the full impact of hurricanes in real time. Researchers commonly use stock and option prices to assess market beliefs regarding a public firm’s current and expected performance. An option, a financial instrument that gives investors the right to sell or purchase a firm’s stock at a particular price in the future, allows investors to hedge, that is insure, against potential stock price changes. For example, investors who are concerned that a stock price could plummet may purchase an option that enables them in the future to sell that stock at a price that is above the low prices they are concerned about. When investors become more uncertain about a firm’s stock price, their willingness to buy the option increases, which in turn drives up the option price. With these dynamics in mind, researchers have used option prices to study the uncertainty of financial market participants regarding firm outcomes (see Bloom 2009; Pástor and Veronesi 2012, 2013; and Jurado, Ludvigson, and Ng 2015).
To estimate how hurricanes affect investor uncertainty about a firm’s performance, we use regression analysis to compare the…