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The Price of Extreme Weather Uncertainty: Evidence from Hurricanes

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Tuesday, February 19, 2019
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12:00 pm - 1:00 pm ET

Abstract: Despite predictions that extreme weather events will increase in frequency and severity due to climate change, little is known about the uncertainty that local economies face because of extreme weather events like hurricanes. This paper investigates the uncertainty of hurricanes through the lens of financial markets. Hurricanes can form suddenly and their evolving paths create substantial landfall uncertainty over several days. After landfall, there remains uncertainty about the actual impact on firms located in the disaster region. We combine firm establishment-level data with novel hurricane forecast and damage data to examine market responses to both impact and landfall uncertainty. We find evidence for impact uncertainty in option and stock prices. In the days following landfall, options for firms exposed to the landfall region exhibit large increases in implied volatilities. In the months following landfall, the underlying stocks have negatively skewed returns. Using the probability distribution of hurricane forecasts as a measure of landfall uncertainty, we show that a reduction in landfall uncertainty leads to impact uncertainty being more strongly reflected in prices, consistent with investors being attentive to hurricane forecasts.

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(Brigitte Roth Tran, Federal Reserve Board)