Option Prices Adjust to Reflect Extreme Weather Events

Stock options of companies with operations in the path of a hurricane reflect higher levels of uncertainty before the storm hits and as the storm makes landfall. It reflects a level of efficiency in how stock and their underlying options are priced.

Stock options of companies with operations in the path of a hurricane reflect higher levels of uncertainty before the storm hits and as the storm makes landfall. While such a finding is not surprising, it does reflect a level of efficiency in how stocks and their underlying options are priced. A market is considered efficient if all known information is priced in, even if the outcomes are uncertain.

Hurricanes can be used to examine how the financial markets price in potential damage from extreme weather events. Storms are tracked before they are named using publicly available and well-publicized data. Forecasts about their direction, intensity and the timing of their expected landfall are also well disseminated. Their timelines are fixed, from formation to landfall to dissipation.

In this study, researchers looked at implied volatility, a component of an option’s value that factors in the uncertainty of future price moves. Higher levels of implied volatility suggest a greater risk of a big price move occurring. Option contracts for companies in the path of a hurricane are priced with greater implied volatility due to investors hedging their portfolios.

As the storm approaches, the strength of the relationship between implied volatility and the location of the companies in the hurricane’s path increases. As forecasters become more certain about whether the storm will make landfall, the implied volatility of companies likely to be affected rises.

Once the storm hits, the extent of the damage is unknown. This risk is quickly priced in with firms that have 100% of their establishments in the disaster region. Options for these companies experience a 10% increase in their implied volatility relative to the period before the storm formed. This number is double the increase associated with uncertainty about election results.

The abnormal returns for most stocks that have at least 50% of their establishments in the disaster region tend to be only slightly negative from landfall up to five days afterward. Extending the window out to 120 days reveals a different story. Companies ranked in the bottom quartile experience an abnormal drop in price (meaning not explained by the market’s performance, their size or valuation) of 12% versus a gain of 3% for companies in the top quartile. Overall, stocks ranked in the median and bottom half experience lower abnormal returns.

Source: “The Price of Extreme Weather Uncertainty: Evidence from Hurricanes,” by Mathias S. Kruttli, Brigitte Roth Tran and Sumudu W. Watugala; SSRN, November 2018.