Climate Risks and Market Efficiency
Research Retrieved: January 2017 (PDF below)
Climate change plays an ever-increasing role in today’s society and the impact of natural disasters caused by, or at least exacerbated by, this change can have severe economic consequences. Especially prolonged periods of drought is considered to be the most devastating consequence for economic production of all natural disasters, a phenomenon that is amplified by global warming. The authors study to what extent previous droughts are priced into the stock prices of food companies that are located in drought-affected countries. They find markets to inefficiently price in these risks especially in countries with a history of relatively few droughts. This finding confirms the concerns of regulators that markets have little experience in dealing with such risks.
The authors look at 30 countries with a sufficiently large food industry (at least 10 food companies). They use the average of the Palmer Drought Severity Index (PDSI) over 12 to 36 months to predict the profitability and excess returns of these food companies.
- 1. Global warming comes along with droughts
The authors show that since 1900 global warming came along with an increasing trend towards droughts suggesting an association between these two occurrences.
- 2. Droughts predict an unexpectedly low profitability in the food industry
Low to severe droughts are correlated with low or negative changes in the food industry profitability ratios in the 12 months following a drought.
- 3. Markets underreact to droughts
The future expected returns of food companies in countries with a drought are lower than those of their counterparts in countries without a drought. This shows that the market is underreacting to drought risk.
- 4. The degree of underreaction increases with less drought experience.
The under-reaction to drought risk in countries with no drought in the past can be more than twice that of countries with a recent drought history. In other words, the predictability of poor returns of food stocks is stronger in countries with previously temperate climates with little history of droughts.
This study might be useful for practitioners interested in the construction of quantitative risk-management models. It sheds light on how to hedge against stock market inefficiencies following an under-reaction to information about prolonged droughts especially since the findings show that PDSI might be a very useful metric of drought to build portfolios and manage risks.