Do Investors Hedge Against Green Swans? Option-Implied Risk Aversion to Wildfires

Measuring beliefs about natural disasters is challenging. Deep out-of-the-money options allow investors to hedge at a range of strikes and time horizons, thus the 3-dimensional surface of firm-level option prices provides information on (i) skewed and fat-tailed beliefs about the impact of natural disaster risk across space and time dimensions at daily frequency; and (ii) information on the covariance of wildfire-exposed stocks with investors' marginal utility of wealth. Each publicly-traded company's daily surface of option prices is matched with its network of establishments and wildfire perimeters over two decades. First, wildfires affect investors' risk neutral probabilities at short and long maturities; investors price asymmetric downward tail risk and a probability of upward jumps. The volatility smile is more pronounced. Second, comparing risk-neutral and physical distributions reveals the option-implied risk aversion with respect to wildfire-exposed stock prices. Investors' marginal utility of wealth is correlated with wildfire shocks. Option-implied risk aversion identifies the wildfire-exposed share of portfolios. For risk aversions consistent with Barro (2012), equity options suggest (i) investors hold larger shares of wildfire-exposed stocks than the market portfolio; or (ii) investors may have more pessimistic beliefs about wildfires' impacts than what observed returns suggest, such as pricing low-probability unrealized downward tail risk. We calibrate options with models featuring both upward and downward risk. Results are consistent a significant pricing of downward jumps.