Financial Sector Stress and Risk Sharing: Evidence from the Weather Derivatives Market

Abstract

I examine the impact of financial sector stress on risk sharing in a novel setting: the CME's weather derivatives market. The structure of the market allows me to disentangle price movements due to financial sector stress from price movements due to fundamentals. In normal times, contracts are priced near their actuarially fair value. During periods of financial sector stress, the risk premium on futures and implied volatility of options increase significantly. The effects are greatest for high margin and high total risk contracts. Consistent with a decline in the supply of financial capital during periods of stress, open interest decreases by over 40% during the recent financial crisis. The results provide causal evidence of the effect of financial sector stress on the pricing of exchange-traded financial contracts and risk sharing in the economy.

Keywords: financial sector stress, weather derivatives, margin, idiosyncratic risk

JEL Classification: G1, G10, G12