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 poor stock returns and profitability ratios for food companies in that country. A long-short portfolio of global food stocks based on PDSI 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 and calls for disclosing corporate exposures. ∗We thank seminar participants at the 2016 NBER Summer Institute Forecasting and Empirical Methods and the 2016 Symposium on Financial Engineering and Risk Management. †Columbia University and NBER ‡Hong Kong University of Science and Technology §Peking University