A Novel Financial Market for Mitigating Hurricane Risk. Part II: Empirical Validation

Abstract

Abstract This paper explores the empirical features of a novel commodity option trading instrument described in the companion paper (Part I) that allows market participants to hedge against the risk that a coastal county or region in the eastern United States will experience a hurricane landfall. In this instrument investors can speculate on whether a landfall event will occur in any one of a number of coastal counties or regions, with option prices being determined by an adaptive control algorithm that reflects previous purchasing decisions of other market participants. In this paper, the authors report the results of an experiment designed to test the empirical robustness of this mechanism using data from traders buying landfall options over the course of a simulated hurricane season. In the experiment traders are given the opportunity to buy landfall options in the primary market as well as sell and buy options in a conventional bilateral secondary market. The data show that aggregate market prices quickly converge to rational (efficient) levels among market participants after limited amounts of trading experience. Some systematic anomalies are observed in the trading of options for individual outcomes, however, with the most notable being an initial tendency to overvalue landfall options that have the highest prior probabilities and for valuations of the “No Landfall” option to be inflated immediately after a storm threat passes without making landfall.