Speculating on Extreme Weather? Harder Than You Might Think

Photograph: NOAA Close

Photograph: NOAA

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Photograph: NOAA

As Hurricane Sandy approaches the New York,  the New York Stock Exchange has closed, shut down by weather for the first time since a Hurricane Gloria, 27 years ago (a decision perhaps helped along by the fact that New York has shut down the subways and evacuated parts of downtown).

Already responsible as of yesterday for 65 deaths in the Caribbean, the hurricane is now threatening much of the East Coasr. In addition to considering the human toll, it's worth thinking about the more general question of how the market handles the "fat tail" risk of a major hurricane. The National Weather Service's excellent hurricane map shows a 30% to 40% risk (that's the yellow band in the map above) of 50-knot (58-mph/93-kmh) winds in New York. 

What you don't see there is the probability of the big outlier event: Sandy remaining at hurricane force (74-mph or greater) as it gets to New York City. The chances of that have fallen since yesterday, when that stood at about 5 percent. 

Considering the magnitude of the shock to the markets, five percent is a meaningful chance. This is exactly the kind of scenario -- a moderate chance of a very large risk -- that many investors have focused in recent years. Did the markets price that in? It's hard to tell. The KBW Insurance Index didn't show much of a hurricane effect, slipping only two percent over the course of last week. That is probably less of an effect than most folks would have guessed.

Another way to take advantage of the downside risk might be to buy put options on the S&P 500 index. If a lot of folks were doing that, you might expect November put options with a strike price of 1350 or 1375 -- that would represent a three or four percent decline in the S&P 500 -- to spike upwards. They haven't.

Recent years have been blockbusters for catastrophically deadly and expensive extreme weather events; Munich Re has some very useful data on this, which show 2011 as a record setting year for costs of natural disasters (this includes Japan's Tohoku quake). While a lot of ink has been spilled about the possibility of hedge funds betting on high-impact, low-but-meaningful-probability events like the storm, that's easier said than done.

It's possible to make a fairly general bet against the insurance industry, or to bet on a sharp drop in the markets. In practice, however, making a specific bet that would hedge against -- or profit from -- a weather disaster is a lot more difficult.There's not a substantial market for, say, put options on the insurance companies with exposure to Sandy.

If you want to hedge the financial risks of a hurricane, there are not a lot of market tools at your disposal. The main hurricane option for investors, whether ordinary stock pickers or hedge fund traders is the same as for other New Yorkers: shut the windows, turn on the news, and watch the storm's progress on TV.

An earlier version of this post appeared this morning in Bloomberg's finance newsletter, The Market Now. Click here to register and subscribe to receive it by email daily. Go to www.bloomberg.com/sustainability for the latest from Bloomberg News about energy, natural resources and global business.

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