Climate Risks and Market Efficiency
We investigate whether stock markets efficiently price risks brought on or exacerbated by climate change. We focus on drought, the most damaging natural disaster for crops and food-company cash flows. We show that prolonged drought in a country, measured by the Palmer Drought Severity Index (PDSI) from climate studies, forecasts both declines in profitability ratios and poor stock returns for food companies in that country. A portfolio short food stocks of countries in drought and long those of countries not in drought generates a 9.2% annualized return from 1985 to 2015. This excess predictability is larger in countries having little history of droughts prior to the 1980s. Our findings support regulatory concerns of markets inexperienced with climate change underreacting to such risks.
We thank Stefano Giglio, Robert Engle, and seminar participants at the 2016 NBER Summer Institute Forecasting and Empirical Methods, the 2016 Symposium on Financial Engineering and Risk Management, the 2016 Research in Behavioral Finance Conference, the Volatility Institute at NYU, and the 2016 NBER Asset Pricing Meetings. The views expressed herein are those of the authors and do not necessarily reflect the views of the National Bureau of Economic Research.