Pricing Poseidon : Extreme Weather Uncertainty and Firm Return Dynamics

We present a framework to identify market responses to the uncertainty regarding both potential hurricane landfall and subsequent economic impact. Stock options of firms with establishments in the landfall region exhibit large, long-lasting increases in implied volatility, reflecting impact uncertainty. Using hurricane forecasts, we find both landfall uncertainty and potential impact uncertainty are reflected before landfall in the options of exposed firms. However, comparing ex ante expected volatility to ex post realized volatility by analyzing volatility risk premia changes due to hurricanes indicates that investors significantly underestimate the uncertainty associated with hurricanes. Since Hurricane Sandy, this underreaction is less pronounced