Blame it on the weather: market implied weather volatility and firm performance

Abstract

We introduce a novel measure of weather risk implied from weather options’ contracts. IVOL captures risks of future temperature oscillations, increasing with climate uncertainty about physical events and regulatory policies. We find that shocks to weather volatility increase the likelihood of unexpected costs: a one-standard deviation change in WIVOL increases quarterly operating costs by 2%, suggesting that firms, on average, do not fully hedge exposures to weather risks. We estimate returns’ exposure to WIVOL innovations and show that more negatively exposed firms are valued at a discount, with investors demanding higher compensations to hold these stocks. Firms’ exposure to local but not foreign WIVOL predicts returns, which confirms the geographic nature of weather risks shocks. Valuation Insight: Exposure to local weather risk is found to be an important determinant of firm value. A one-standard deviation increase in weather risk, as inferred from prices of weather options’ contracts, increases firm operating costs by 2%. Firms with more exposure to weather risk appear to have a substantial value discount to explain higher observed future return averages of around 5% annually between high-exposure and low-exposure firms.